The MTFS or the EMS: Which Way for Credible Monetary Policy?

Abstract

Since the latterpart of 1988, theprimarypolicy objective has been to heqd off a rise to double digit inflation. T o this end, interest rates have been raised from 7112 per cent to 14per cent, while the public sector is running a large fiscal surplus. Despite this apparently very tight policy stance, policy is deficient in a crucial respect: it lacks credibility. The all too public divisions within government have weakened the efficacy of monetary policy, especially in financial markets. .The ongoing uncertainty over who is in charge of the conduct of policy -No. 10 or No. 11 -further undermines confidence. The most urgent priority must be to reassert clear priorities and guidelines. In this Viewpoint, we consider how best to restore the credibility of monetary policy. There are two main possibilities: first, t o reassert the Mediultt Term Financial Strategy (MTFS) in an appropriate form; or to join the (Exchange Rate Mechanism of the) European Monetaty System (EMS). We argue that it will be very hard t o derive credibility benefits from a reassertion of tlie MTFS: because of tlte itijlation record of tkepast decade atid the twists and tunts of past versions of the MTFS, a mere restatement will not resolve the uncertainties that result from known differences within the government. In particular, any restatement will rely 011 discretion and judgement in its implementation and this will weaken its beneficiol effects on expectations.Instead we argue that entry into the EMS offers a tougher and more credible commitment for monetary policy. The Chancellor has been pushed to rule out UK entry until the second harfof 1990 at tlte earliest, but tlie government should make a virtue of this by announcing a finn dale for entry next yeor. In the interim, it should encourage a debate about the appropriate rate for entry, a debate which will increasingly guide the foreign exchange market. The government should make it clear that i n choosing this rate it will d o so with the commitriient to low inflation very much in mind, favouring a high exchange rate. Once in the EMS, tlie government slioirld rule out the possibility of devaluing the pound in an EMS realignment. This provides a firm noti-discretionary anchorfor botli nionetary policy and inflation expectations. With this commitment, the principal gain from EMS entry will be establishing a regime of low inflation for the n u t decade: in this, choice of the exchange rate will be less crucial than tlte fact of entry.

UK supply performance and company behaviour

“…With a good cushion of profitability, buoyant investment and high export growth can be consistent with continued tight money and "If the restoration of profitabili4' has proved supply responsiveness, theprospectsare nor as grim. I' Currie and Dicks, 1989.) This more optimistic scenario depends critically on corporate responses.…”

“…broad monetary aggregate, notably EM3, as the cause of the recent boom. However, as Currie and Dicks (1989) argue, EM3 has proved a very unreliable policy guide over the past decade. Moreover, the spurt in the growth of EM3 in 1986 is attributable to the end of over-funding.…”

“…It can even be consistent with a policy of bringing inflation down more rapidly by commitment to UK entry to the Exchange Rate Mechanism of the European Monetary System at a high exchange rate (with associated credibility benefits). (SeeCurrie and Dicks, 1989. )…”

Options for ERM Entry

“…In our view, there are several major difficulties with thii option. (For further discussion see Currie and Dicks, 1990.) The first is that the low initial exchange rate considerably exacerbates the transition'd problem of bringing UK innation down.…”