A good start to life under Labour

The next test of the new Government's credibility will come in the Budget
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The Independent Online
So, life under Labour has begun with an outburst of the much lamented feelgood factor in the financial markets. This, I hope, will not come as a complete surprise to readers of this column. A few months ago, I quoted the views of Stephen Lewis, the experienced bond analyst, that foreign bond investors would react warmly to news of a convincing victory by a moderate Labour Party apparently committed to stern anti-inflationary policies and the pursuit of greater integration with Europe.

And so it has proved: the markets like certainty more than anything else, and there is nothing if not durability in the prospect of a government with such a large majority.

The big surprise so far of course has been Gordon Brown's rapid and unexpected move to give control over the setting of interest rates to the Bank of England. The markets had already largely bought the argument that Labour is now a seriously moderate party shorn of its old tax-and-spend habits. But Mr Brown has moved quickly to shore up the Government's credibility with the "bond market vigilantes" still further by pre-empting any lingering uncertainty about the seriousness of his intentions to avoid taking political liberties with interest rates.

This is a profound and historic change in the way that we conduct our economic policy. If it works out as presented, investors will have good cause to celebrate the slaying of one Labour bogeyman: that it is the party of inflation. Last week's market reaction was certainly encouraging. Short-term rates went up, as the Bank of England wanted, but the yield on long-term gilts - which is the one that ultimately matters most for industry and investors - fell quite dramatically. The stock market was also up 4 per cent in a week by midday yesterday.

This is exactly what you would expect to happen if the markets had accepted that long-term inflation prospects have improved as a result of the new monetary policy arrangements. The whole rationale of central bank control of interest rates is one of "short-term pain, long-term gain". The more credible the anti-inflationary strategy is seen to be, the more quickly long-term interest rates can fall and the more benign both the economic and investment environment will become.

That's in theory: of course the new arrangement has still to be made to work in practice. While there is clear evidence that countries with independent central banks tend to have lower rates of inflation than those which do not, what Mr Brown has proposed is only a halfway house towards full independence.

We don't know how the new monetary policy committee at the Bank, with its "expert" members nominated by the Chancellor, will work in practice. It is worth remembering that most of our leading economic competitors have arrangements which already give their central banks more control than the Bank of England will have - so the change, while radical in our terms, will not give us any competitive advantage over other countries.

The new arrangement, while agreeable to contemplate, is certainly not yet a guarantor of improved economic performance. There is no law which says the Bank will be any better at reading the economic runes than anybody else, and in fact its recent record in predicting inflation and the level of economic activity has been patchy at best. Nor does the new arrangement actually guarantee that politics will be taken out of interest rate decisions. Even in countries such as Germany and the United States, where the central banks have much greater constitutional freedom than ours, they are constantly engaged in behind-the-scenes battles with governments intent on keeping the economy moving along.

Still, there is no reason to be grudging about accepting the thrust of what Mr Brown is trying to do or about believing his intentions. Assuming the economic climate remains as benign as it is today, investors are right to take comfort from what has happened. A period of low inflation, coupled with a Government that seeks to retain tight control over the budget deficit and is committed to supporting business (if those two promises also turn out to be true), should hold no great fears for investors.

The next test of the Government's credibility will come in the Budget. How far will Mr Brown move to fill the gap in the public finances by additional taxation on companies? Raising the rate of corporation tax by 2 per cent would raise pounds 2bn and must look a tempting target, given the strong recent rise in industry's return on capital. And how far will he move to cut the tax privileges of the pension funds by restricting further the advance corporation tax credit on dividends? Either step threatens to put a lid on the scope for the stock market to move ahead. Over at the Department of Trade and Industry, meanwhile, we wait to see how the new ministerial regime rules on the various bids and deals awaiting merger clearance. It will be a good litmus test of the Government's professed desire to promote competition.

It is true that Labour governments have not traditionally been as good for the stock market as Conservatives ones. In nominal terms, the returns on shares might appear to tell a different story, but if you look at real returns (after inflation) the story is clear enough, as my chart shows. For obvious reasons, industrial shares have tended to do better under Labour in the past than financials, and vice versa under the Tories. Because of its poor inflationary record, the returns on gilts have also been inferior under Labour. Such parallels with the past have only limited relevance today, however. After all, we have never before had to deal with a Labour government which is trying so hard to emulate - or, in the case of this week's monetary policy changes, to outdo - what are traditionally thought of as Tory policies.

Before embracing too readily the message that New Labour will be good for investors, don't forget: (a) that stock markets are already highly valued in historical terms; and (b) that we cannot divorce our fortunes from those of the rest of the world. A timely study this week from PDFM, the fund management group, reminded us that the UK stock market has out- performed all other leading stock markets since the dark days of 1975.

As Warren Buffett, the legendary American investor, also pointed out this week, the stock market cannot go on producing its current exceptional rates of growth forever. Even if the risk from a Labour government has diminished, the risk of mean reversion remains. And, of course, one bold announcement does not remove the risk that New Labour will be bounced out of its confident stride by the turn of unforeseen events. Still, after last week's welcome beginnings, nothing has changed my view that gilts remain a sound bet - and who would have thought one could ever have said that with a Labour Chancellor newly installed in Downing Street?

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