The prime role of monetary policy is to control inflation. Since the Conservative administration came to power with the avowed intention of taming inflation by stringent monetary control, the underlying rate has been reduced to a low of 3.5 percent in 1986. But it has been rising ominously since the late 1980s. Has United Kingdom monetary policy therefore failed in its primary purpose? If it has, what has gone wrong?
In Money, Credit, and Inflation, Professor Gordon Pepper seeks the answers by studying the relationship between the main indicators of money supply - M0 (the narrow monetary base) and M4 or M5 (the broad measures) - and movements in the interest rate (base rate), the main tool for controlling inflation used by the UK authorities over the last decade. From his analysis he concludes that the tools were - and remain - inadequate. M0 is a good indicator of inflationary pressure, but only coincidentally - it does not serve as a leading indicator. The control mechanism, which can correct only minor deviations from the desired path, is weak; interest rate changes have very little direct impact; their indirect effect may not even be powerful unless they are large enough to shock confidence.
The real problem, says Professor Pepper, is that the Bank of England does not control the growth of credit. It acts only as a 'passive supplier' of liquidity to the banking sector. The recent boom in credit, encouraged by Chancellor Lawson's tax-cutting Budget of 1988, as well as other Treasury mistakes, was insensitive to even drastic changes in interest rates and consequently fuelled the dramtic growth of the money supply.
About the Author:
Gordon Pepper, CBE, is a Director of Midland Montagu and Visiting Professor and Director of the Centre for Financial Markets at the City University Business School.