A cut that could break the Bank's chains
Sunday 09 June 1996
From a purely economic point of view the odd quarter percentage point off or on base rates might not seem an earth-shattering event. If it does prove unsustainable, they can always stick rates up again. But in terms of politics it is important because once the Bank of England can point to a Chancellor making a clear error on interest rates, its own credibility will be enhanced. In a way, the Bank almost needs Mr Clarke to make a mistake to underpin its case for independence. It needs to be able to show that electioneering governments get interest rates wrong in order to support the argument for taking that power away from them. We do not yet know for sure the truth of speculation that the Bank opposed last week's cut in base rates to 5.75 per cent. But if it is shown that it did, and if subsequent events support the view of the Bank, then it will have scored an important "hit" in its quest for greater autonomy.
As to the issue itself, on Thursday, after the announcement, the professionals were split pretty evenly. Some argued that the weakness of manufacturing and the rise of sterling made the cut desirable; others reckoned that the already evident growth of consumer spending and the relative strength of the housing market suggested that a mini-boomlet was on the way and needed no further spur from lower interest rates.
By Friday the mood had shifted against Mr Clarke. The reason lay in yet more employment figures from the US which suggested that the economy there was growing more quickly than had previously been thought. This increases the chance of an early rise in US interest rates, which might be expected to put pressure on the UK.
The idea that US interest rates are more important to Britain than continental ones is intriguing. Surely, since nearly 60 per cent of our exports go to Europe, what happens to the European economy is more important? Certainly our exports to the rest of Europe are not very buoyant for just that reason, but if you look back through the last recession, the UK economic cycle appears more closely synchronised with North America than with Europe. The graph on the left shows how we bottomed out within a few weeks of both Canada and the US, whereas Germany, France and Italy all hit bottom nearly two years later.
So, the argument goes, if the US economy seems to be putting on a bit of a spurt, that may indicate that growth will continue strongly here. If economic cycles are synchronised, interest rate cycles will tend to move together too.
That is a persuasive argument and naturally has implications for European Monetary Union. One could argue that were we part of a single currency our economy would be forced to move with Europe, rather than North America, because we would have European interest rates imposed on us. But surely the experience of sterling's ERM membership, which highlighted the dangers of a "wrong" interest rate policy, carries greater weight. In any case, the point is that if US rates do go up in the summer, we may well find our own rates rising in the autumn whether we like it or not.
The Chancellor, naturally, would not for the most obvious of reasons: not only would that suggest that he had been wrong in the latest cut, but the Tories would find themselves hitting the election in a period of rising interest rates.
There is, however, one possible argument which runs in Mr Clarke's favour. Have a look at the graph on the right. That shows British interest rates and the savings ratio since 1970. You can see that the two lines pretty much track each other until the middle 1980s. When interest rates were high savings were high, and when they came down savings came down. There may not have been a strong causal relationship between the two, but there was some sort of relationship. Then in the mid-1980s things changed. Savings came down when interest rates went up. That was a key characteristic of the late-1980s boom. Now, in the uncertain mid-1990s, the reverse has happened. We have maintained a reasonably high savings ratio (maybe not high enough, but that is another issue) despite the fall in base rates.
Insecurity has meant that one of the more dangerous effects of overly- low interest rates has not happened, and arguably we actually need low interest rates to sustain the economy in this uncertain environment. Even if our present level of interest rates proves wrong, it does not matter too much; we can always stick them up again.
Nevertheless, a mistake by an electioneering Chancellor would be significant. There is plenty of evidence in the past of monetary errors as a result of an overly political judgement: policy was too loose in the 1980s partly because Nigel Lawson chose to shadow the German mark, and to hold down sterling we had to have inappropriately low rates. Going further back there was the Barber boom and further still, the Maudling boom. Clearly Tory governments are particularly prone to make errors of monetary policy, while Labour ones are prone to errors of fiscal policy.
One of the effects of the Maastricht Treaty has been to give central banks all around Europe greater independence, with the effect that the Britain is now unusual in retaining the formal control over short-term rates in the Treasury. So it does seem likely that in the life of the next parliament some further measures will be taken to heighten the Bank's independence. Labour is in part committed to it, and the Tories would probably be forced in the same direction. Central bank independence is a bit like privatisation: once one country starts doing it, others have to follow.
So it will happen. Nevertheless, the Bank's authority as an independent body will be vastly greater if it can be shown to have been right a couple of times about monetary policy. Independence is not simply enshrined in a charter, though the legal form does matter a lot. Independence is enhanced by market credibility. The US Federal Reserve has that; so does the Bundesbank. The Bank of England will need, over a period of years, to build it. Getting wrong-footed last year by the Chancellor did not help.
So if Mr Clarke is wrong and that last rate cut proves an error, and assuming the Bank did oppose it, we may end up with quite a satisfactory outcome. We will have had an interest rate cut which has to be reversed, but will not be particularly damaging to the real economy. And we will have a significantly stronger Bank of England, which will have won its spurs by opposing pre-election rate cuts.
If, on the other hand, Mr Clarke proves right after all - another 10- 1 bet comes off - he will be allowed a quiet chuckle. The Bank, for its part, will look a bit soft. But that has happened before.
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