UK Macro Policy
A new medium-term framework

For the past six years, macroeconomic policy in the United Kingdom has been conducted within the framework of the Medium Term Financial Strategy (MTFS). At a May 21 lunchtime meeting CEPR, Programme Director David Currie argued that, even without the benefit of hindsight, we can see that it contained important flaws in its design. The MTFS neglected output movements and real exchange rate variations in the single-minded pursuit of lower inflation, thus damaging prospects for the real economy in both the short and the long run. These flaws have led to significant changes in the operation of the MTFS, as policy- makers have experienced and sought to ease the constraints that it imposes. A medium-term framework for macroeconomic policy is necessary, but Currie argued that the correct framework should combine assurances about medium- to long-run inflation performance with greater stabilization of the real economy. Currie argued that, in contrast to the present MTFS, this policy framework would be consistent with recent proposals for increased coordination of macroeconomic policy between the major industrial countries.

David Currie is Professor of Economics at Queen Mary College, London, and Co-Director of CEPR's International Macroeconomics research programme. He is currently visiting the National Institute for Economic and Social Research, having recently been the Houblin-Norman Research Fellow at the Bank of England. He is also economic adviser to Roy Hattersley, the Shadow Chancellor, and a Trustee of the Employment Institute and Charter for Jobs. The analysis he discussed at the lunchtime meeting was based on joint research with Dr Paul Levine of the London Business School.

Macroeconomists had identified serious weaknesses in the MTFS at its inception, and their analysis has been borne out by experience. Currie and his co-authors, for example, had produced simulations (reported in CEPR Discussion Paper No. 78) of the behaviour of policies based on Public Sector Borrowing Requirement (PSBR) targets. They discovered that such a policy rule is unstable: in periods of falling aggregate demand, when government revenues also decrease, tax rates must be increased or expenditure cut to achieve the PSBR target. This causes aggregate demand to fall even further, resulting in a fiscal policy which responds perversely to fluctuations in real demand and output, and which increases the volatility of the real economy. Currie added that in addition to its tendency towards instability, the MTFS has also obliged the government to forgo opportunities for productive investment in the public sector.

Monetary policy has also experienced difficulties. The central role given to targets for monetary aggregates was a serious error. Financial innovation and liberalization over this period robbed these aggregates of whatever informational content they might otherwise have had. The usefulness of targeting short- term movements in aggregates that act as buffer stocks for the private sector is far from evident. Most seriously, the focus on monetary aggregates left the exchange rate vulnerable to Dornbusch-type overshooting and other speculative influences.
Policy-makers now find it more difficult to interpret movements in monetary figures correctly and have therefore abandoned traditional indicators. In addition, the basis on which the targets for these aggregates are calculated has tended to 'drift' over time. Currie claimed that as a result, monetary targets now offer less credible guarantees that inflation will be controlled in the medium and long run. Adherence to these targets has also meant that policy has ignored movements in the foreign exchange market, resulting in unprecedented volatility in the real (and nominal) exchange rate.

Macroeconomic policy had responded to the difficulties created by the MTFS, Currie noted. There has been a gradual shift towards discretion in policy, although the overall objective of lower inflation remained. Monetary policy has been increasingly conditioned by the exchange rate, although in what precise manner remains unclear; asset sales have also permitted a more expansionary fiscal stance within given PSBR targets. Currie claimed that the key to current policy is the government's and Chancellor's reputation for the determined pursuit of stable and low inflation, rather than the particular monetary and fiscal targets they have adopted. But the vagueness of current policy may well diminish its effectiveness; and the policy still lacks coherence in key respects, not least in the absence of a clear medium-term framework.

Despite the deficiencies of the MTFS, Currie argued that a medium-term framework for monetary, fiscal and exchange rate policy is nevertheless desirable, because it encourages more predictable policy responses. This can help to stabilize asset markets (such as the foreign exchange market) which are influenced by expectations of future government policies. Such predictability also improves the functioning of the real economy, particularly when decisions (such as investment) must be taken over a long horizon. The medium-term framework also provides government with a structure within which the competing claims of different government departments can be assessed. In addition, it permits governments to establish, maintain, and make use of a reputation for consistency and predictability in the conduct of policy. Recent research by Currie and Levine (reported in Discussion Paper Nos. 94 and 102) and by David Backus and John Driffill (in Discussion Paper No. 63) suggests that policy may be significantly more effective if the government has established a reputation of this kind.

A satisfactory medium-term framework should provide assurances on both the nominal and real sides of the economy. The key nominal factor is the behaviour of the inflation rate in the medium to long run: this must be predictable, so that companies and individuals can enter into longer-term contracts without undue risk. Assurances on the real side should not conflict with such inflation guarantees. But, Currie argued, there is only a loose relationship between inflation and demand in the short run and this gives ample scope for policies which avoid excessive short- run fluctuations in the real exchange rate or in aggregate demand. It was important, Currie emphasized, to prevent such fluctuations, which seriously disrupt investment and international trade and damage the economy's long-term growth and employment prospects.

Currie outlined two alternative medium-term frameworks. The first involved modifications of current policy. Fiscal policy could be operated in a more flexible manner to stabilize real output, at least allowing automatic fiscal stabilizers to operate, and perhaps with an additional measure of adjustment as well. Monetary policy would continue to be assigned to stabilizing nominal trends in the economy. The medium-term nominal target could well be expressed as a trend path for nominal GDP. This has the advantage of combining both output and price movements in a single index, although some might object to the implied one-for-one weighting.

To guide monetary policy, a variety of indicators could be used. The exchange rate would be a key indicator, both because it is a powerful influence on domestic price and wage setting and because it provides a useful indicator of market expectations. Domestic wage settlements would also be important as indicators of domestic cost trends. The two might usefully be combined in a measure of domestic unit costs, which some evidence suggests provide a useful lead indicator of future price trends. Monetary aggregates may also play a role, as could forward-looking asset prices other than the exchange rate. But these variables would act as indicators for policy, not as intermediate targets. Moreover, their influence on policy may vary over time depending on the evidence available. Currie argued that the most promising approach to the indicator problem would be an application of Kalman filtering, which would explicitly allow for the possibility that the influence of these variables can vary over time. Such a technique could detect useful short-term information in relevant variables without presupposing a stable long-term relationship. The authorities could, and should, be open about the technical evidence on which current short-term monetary reactions are based. This will aid credibility and also allow greater scope for informed private sector research to influence the thinking of the authorities.

One objection to this policy mix, Currie acknowledged, was its failure to provide a clear anchor to the foreign exchange market, a weakness that it shares with monetary targeting. As such, it leaves the exchange rate prone to speculative bubbles and undue volatility. This could be avoided by elevating the nominal exchange rate to the status of an intermediate target, possibly in the form of 'conditional exchange rate targeting' proposed by Currie and Michael Artis in 1980.

A danger with this particular framework - of using fiscal policy to act on real output while using monetary policy to stabilize domestic nominal trends - is that it may well generate inconsistency between the stance of monetary and fiscal policy. It is, after all, the policy combination adopted by the Reagan administration in the United States. Such inconsistency can be deeply damaging internationally. It can generate prolonged misalignments of real exchange rates, with consequent distortions to industrial development, loss of capacity and threats of protectionism. When carried out by a major country such as the United States, it exports inflation and high real interest rates to the rest of the world, with disruptive consequences for public finances and debt service, particularly in developing countries. A regime of this kind is likely to be rather unstable, and prolonged misalignments of this type are one of the major reasons why the performance of floating rates has been so dismal.

But the problems of such policies may also be felt even when a single country pursues them alone. Misalignments also build in long swings in adjustment: the interactions from competitiveness through to net exports, back onto demand and hence on prices and competitiveness can take place over very long periods; and the dynamics of stock-flow adjustments through the current account and net international asset positions are still more prolonged. A government with a short horizon may choose to disregard such effects, but a medium-term framework that offers no corrective to these complex dynamics provides little assurance for medium- to longer-run stability. Moreover, the international coordination of policy is difficult within this framework: the use of the exchange rate for anti-inflationary purposes is inappropriate in the face of general world inflation since all countries cannot pursue this policy simultaneously.

In view of these difficulties, Currie suggested an alternative framework which operated to stabilize simultaneously the real exchange rate and domestic nominal trends. This would involve the use of the fiscal and monetary policy mix to stabilize the real exchange rate in a way consistent with external balance, while the overall combined stance of fiscal policy would operate on domestic nominal trends. In practice, Currie argued, in a world of high international capital mobility, this is likely to mean the assignment of monetary policy to the real exchange rate and fiscal policy to domestic nominal trends, as James Meade and others have suggested. It should be noted that providing a nominal anchor via fiscal policy is an essential prerequisite for operating on the real exchange rate, for without the anchor, uncertainty about future inflation trends would destabilize the foreign exchange market.

This policy framework would avoid undue fluctuation in the real exchange rate, and is therefore consistent with recent proposals, associated with John Williamson, for exchange rate zones for the major international currencies. Hence it is consistent with possible schemes for extending the degree of cooperation between the major industrial countries. This is desirable since there is no reason to suppose that each country putting its own house in order will create a stable international macroeconomic environment. In targeting of the real exchange rate, Currie noted that there was a case for adopting a wide band. This is not in order to simulate a crawling-peg regime with a rapid rate of crawl, which might destabilize domestic inflation objectives, but rather it may be advantageous to maintain a narrower 'shadow' band, using the flexibility offered by the wider band to avoid a one-way option for short-term speculators.

This policy framework could be implemented within the context of the European Monetary System, which would enlist additional central bank cooperation and policy coordination in pursuing the exchange rate objective. But Currie doubted whether EMS membership with narrow intervention bands would be feasible without the imposition of tight controls on short-run capital movements.