Published:

Follow Andrew Lilico.

As expected, the main macroeconomic policy action in the Budget wasn't in the fiscal area at all – overall it was "fiscally neutral", i.e. it didn't seek to use new policy measures to increase or decrease the deficit.  That means the government has given up on cutting the deficit for years – the deficit in 2011/12 was £120bn; the deficit in 2012/13 has been £120bn, and the deficit in 2013/14 is now scheduled to be… £120bn.  In what universe leaving the deficit exactly the same for three years in a row, at £120bn, counts as "austerity" I'm not sure – but it's not one I live in.

On fiscal policy, the best one can hope for is that the government actually implements its spending cuts programme, which it has now finally got seriously into - perhaps around one fifth of the way through. One monetary policy, on the other hand, the government thinks there's still further it can go. The Chancellor announced a change in the Bank of England's "remit" – i.e. the target it is set and the way it is instructed to meet that target.  In essence, the Chancellor sent the Bank a letter saying: "Your remit is changing.  Although the target is still 2% inflation, you are henceforth allowed to be as far above the target, for as long as you like."  Perhaps the most telling thing about this change was that everyone has shrugged and said: "But that was the practice already!"  Regardless of what the old remit formally said, it has been clear for the past six years, since the inflation target was first breached in the year to March 2007, that the inflation target in no way restricted interest rate setting in this country.  There has been no effort to keep inflation to target, and no restriction on how far inflation was permitted to deviate from target, and successive Chancellors have rubber-stamped that policy by never once admonishing the Bank of England for its repeated misses of the target.


What policymakers appear to want to do is to create "flexibility" for themselves such that when recovery finally comes, and with it a rise in inflation, the Bank does not feel pressured to raise interest rates early in that recovery, choking off growth or perhaps even pushing us back into recession.  They want to see real terms growth of perhaps 3% per annum for a couple of years, until we have achieved escape velocity from the current slump, before being tempted to raise rates.  Of course, that is going to mean inflation spiking way above target.  We have seen over the past six years that whenever the economy isn't actually shrinking, inflation goes to 5% and rising.  How much inflation do you suppose there will be if growth actually gets going?  8%?  10%?  Once inflation reaches these sorts of levels and interest rates are still down at 2% or below (as the new inflation targeting regime implies should be permitted), will policy be able to catch up?  As I pointed out nearly three years ago, once inflation reaches these sort of levels, if the economy were healthy we'd need to have interest rates at least a couple of percentage points above inflation in order to get it down.  But, as I also pointed out then, there continues to be a severe risk that the economy will not be healthy enough to sustain such high interest rates, with the consequence that policymakers feel they must let the inflation rip for some time until eventually they must raise rates enough to induce a severe recession, just to get inflation down.

In mid-2010 I warned that the "optimistic case" scenario was that the government's growth figures could prove correct but only at the expense of inflation peaking at 6%.  Of course, UK policymakers failed to enact QE early enough and abandoned their deficit reduction plan, and the Eurozone crisis stunted growth, so the double dip I predicted (and was widely mocked for predicting) was much more protracted than expected, and the 2011 inflation that I predicted (and was widely mocked for predicting) was chocked off by recession before it peaked.  So we weren't in my optimistic case.  From here, I see little prospect of policymakers keeping inflation to a 6% CPI peak – nor indeed any appetite on their part to do so.  I now say 8%, but fear that (absent a euro collapse or UK banking collapse that could yet plunge us into deflation) most of the risk to that is on the upside (i.e. peak inflation is more likely to be higher than my base case, rather than lower).

The new Bank of England remit is being described as "flexible inflation targeting", but is better known by its more traditional name: "not targeting inflation."  Not targeting inflation has a long and inglorious history.  Policymakers have often felt that just a little more inflation would make their lives a lot easier.  Whether they were ever correct in that or not, "just a little more inflation" is rarely achievable.  Once inflation goes much above about 5% it will become much more volatile as well as higher – it is very hard to have inflation stable at around, say, 7% per year.

Once recovery gets going, QE-induced broad money expansion will accelerate – the "ketchup in the bottle effect" will kick in – and inflation will rise.  Policymakers will eventually try to get inflation down.  When they start to act, they will hope to manage public expectations about inflation – they will say something like "Please, firms and workers, make your pricing and wage demand decisions over the next year based on inflation being 5% not 10%, as we shall set policy at 5% and if you over-price and get over-paid, there will be bankruptcies and unemployment."  An important tool policymakers developed in the late 1980s for managing public inflation expectations was the "inflation target".  Under inflation targeting, policymakers announced that in some specific year (not vaguely, "at all times", as the UK framework has evolved to be understood), inflation would be X% and the following year it would be Y% and, the year after, Z%.  Having made such commitments, they aspired to stick to them regardless of the consequences.  They knew that unemployment might rise or other shocks might occur, but there's no point in making a promise if you stick to it only when things are convenient – then it would be not a "promise" but merely a "prediction".

Because we have inflation coming, and when we try to get that inflation down we will need to manage public inflation expectations by being able to make credible promises that we stick to whether it is convenient for us or not, we desperately need to establish for ourselves a monetary policy framework.  That is to say, we need to set out some rules that constrain what the Bank of England is permitted to do – rules that are not mere predictions of or aspirations for its actions but actually constrain them – and then the government needs to enforce those rules.

Such a rule, since it constrains action and does not permit unrestricted deviation from the policy just because of inconvenient circumstance, is precisely the opposite of the sort of rule George Osborne set for the Bank of England yesterday. Osborne says the Bank should be able to deviate as much from the inflation target as it likes, for as long as it likes.  But that is not a framework for constraining monetary policy.  Millions of unemployed people in the future will pay the price of Osborne's error yesterday.

Comments are closed.