Inflation would slowly come back on track, but only at the expense of what would feel like a long and deep recession.Now let us turn to the second graph, which shows what would happen if the Bank makes a mistake in the direction of “policy overkill” in the near future. This seems politically infeasible, since it would mean the total abandonment of the government’s 2.5 per cent inflation target.Accordingly, scenario two shows what would happen if the Bank opted to get inflation back on target by the end of the Parliament. In scenario one, the Bank seeks to avoid a hard landing, and slowly squeezes GDP growth down to zero over a three-year period. The trouble with this scenario is that output remains above trend for some time, so inflation continues to rise until the end of the year 2000, by which time it has reached 7 per cent. This is set to triple, helped by huge advances in genetics and combinatorial chemistry, which can cut new product development time in half. Output is 3 per cent above trend, and inflation is rising by almost 0.5 per cent a quarter. From then on, all choices are unpleasant, and there is no happy exit from the mess by the end of the Parliament.The graph shows two possible choices from then on.

The first graph shows what would happen in the case of “policy underkill” – a situation in which the Bank does not tighten policy enough, and in which GDP growth persists at about 4 per cent next year By the end of 1998, the die is cast. This is a very good outcome, but it is a knife-edge solution which can only occur if everything works out perfectly.The graphs show what would happen if, instead, the economy does not respond exactly as expected to the Bank’s tug on the policy reins in the next 18 months. The stance of fiscal policy is tightening sharply because of the Chancellor’s tough public spending plans, and overall monetary conditions have similarly tightened with the rise in base rates and sterling.With today’s policy settings, output growth should slow to 2.3 per cent in 1998, the positive output gap will never become too large, and inflation will be curtailed at roughly 3 per cent in 1999. The adverse impact of this situation on inflation is temporarily being disguised by the rise in the exchange rate, but this is unlikely to persist indefinitely.

Hence the urgent need to bring output growth back to its trend rate of 2.5 per cent or so.The good news is that, on the consensus view of prospects for next year, this is exactly what will happen. But time is getting short, and the likelihood of being lucky enough to judge the stance of policy just right is undoubtedly diminishing with every month that passes.After last week’s strong GDP statistics, Goldman Sachs reckons that the true level of output in mid-1997 – after making appropriate adjustments for the likely future upward revisions to GDP statistics – is already about 1 per cent above trend, and the positive output gap is rising all the time. When we allow for the fact that it takes some time, perhaps a couple of years, for output to shift from 2 per cent above trend to 2 per cent below trend, it becomes plain why it takes so long to regain control of inflation once it has been let out of the bag.Fortunately, inflation has not yet been let out of the bag, so it is still possible that we can avoid all of these unpleasant consequences altogether. In order subsequently to get inflation back down by the same amount, output needs to be 2 per cent below its trend level for two years. The model is symmetrical between positive and negative output gaps, and interestingly finds almost no independent role for the exchange rate to influence inflation over the long term.The elasticity between the output gap and inflation may not appear to be very large, but of course inflation continues to rise indefinitely for as long as output is above trend, so the cumulative effects of a policy mistake on inflation become very sizeable and persistent over time.For example, if output is 2 per cent above trend for two years, then inflation will have risen by 2.4 percentage points from its starting rate by the end of the period. This was first estimated by David Walton of Goldman Sachs a few years ago, and while it is extremely simple, it captures the main features of the inflation process, and has operated with a tolerable degree of accuracy for some years.
Essentially, the model suggests that for every 1 percentage point of output gap, the inflation rate will change by 0.15 percentage points per quarter. For, if it makes the opposite mistake, the mopping-up operation could last the entire Parliament.

These results follow from a standard model which links the degree of spare capacity in the economy – the output gap – with the change in the rate of inflation. Monetary policy is a matter of assessing the balance of risks. In an uncertain world, is it better, at any given time, to err on the side of policy overkill, or policy underkill? This column will argue that, in present circumstances, the incentives on the Bank are clearly in the direction of risking overkill. Glaxo people felt initially like a predator that had caught something. But when we took the decision to manage it as a merger, the only person who knew he had a job, was Sir Richard,” says Mr Lance.This amounts to only the beginnings of a strategy. But with Glaxo in good shape, investors would not thank him for undue haste At just 49, Sean Lance has plenty of time He has only just started to climb his hill.Sameena Ahmad. The potential payback, given margins of over 30 per cent, is enormous.There are also gains to be had in manufacturing, traditionally an area neglected by drug companies.

Glaxo still has 40 production plants around the world and could probably live with half that. The group recently raised almost pounds 200m from selling two factories to suppliers, suggesting there is plenty of capital to be liberated and ploughed more profitably into R&D.Mr Lance’s short-term goal, however, is to improve communication between the group’s 54,000 employees and open the company to the outside: “What we haven’t really done successfully yet is expose investors to the depths of management at Glaxo It is not just about one or two key individuals Those who see us close up are always surprised. If you are number one, you can attract top people – just like Manchester United does.”Fostering a more open culture is one of management’s most difficult tasks, but Mr Lance’s approachable manner is, at least, very different from the slightly arrogant Glaxo style of old.What he is not thinking of is another takeover “Do it again? Not easily It was a big shock. Glaxo’s annual spend on R&D is typically 14 per cent of sales, yet historically it has brought only one significant drug to market every year. Right now the sales force is selling only one or two new products That’s easy Now they will have to sell four or five.