Credible Benefits Research Articles

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

Since the latter part of 1988, the primary policy objective has been to head off a rise to double digit inflation. To 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, to reassert the Medium Term Financial Strategy (MTFS) in an appropriate form; or to join the (Exchange Rate Mechanism of the) European Monetary System (EMS). We argue that it will be very hard to derive credibility benefits from a reassertion of the MTFS: because of the inflation record of the past decade and the twists and turns 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 on discretion and judgement in its implementation and this will weaken its beneficial 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 half of 1990 at the earliest, but the government should make a virtue of this by announcing a firm dale for entry next year. 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 in choosing this rate it will do so with the commitment to low inflation very much in mind, favouring a high exchange rate. Once in the EMS, the government should rule out the possibility of devaluing the pound in an EMS realignment. This provides a firm non‐ discretionary anchor for both monetary policy and inflation expectations. With this commitment, the principal gain from EMS entry will be establishing a regime of low inflation for the next decade: in this, choice of the exchange rate will be less crucial than the fact of entry.