The curious case of the two-direction economy

The 2001 consumer has been only a very poor cousin of his or her 1980s counterpart
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The Independent Online

In Through the Looking-Glass, the White Queen boasted that she could believe six impossible things before breakfast. Of course, she never got the chance to ponder on the current situation in the UK economy. But had she done so, she might have thought about the impossibility of rapid house price inflation at a time of manufacturing recession. Can the two really be happening at the same time?

In Through the Looking-Glass, the White Queen boasted that she could believe six impossible things before breakfast. Of course, she never got the chance to ponder on the current situation in the UK economy. But had she done so, she might have thought about the impossibility of rapid house price inflation at a time of manufacturing recession. Can the two really be happening at the same time?

Well, obviously they can. The latest Nationwide house price index shows house prices up 10.9 per cent over the past year. At the same time, manufacturing output has fallen for two consecutive quarters, fulfilling the so-called "technical" definition of manufacturing recession.

"Curiouser and curiouser", as Alice might say. And there have been some fairly curious reactions to these developments. Some argue that house price inflation is the beginning of an inflationary surge for the overall economy, conveniently forgetting about the manufacturing collapse. Others suggest that the economy is heading straight into recession, ignoring the persistent strength of the housing market and consumer spending. And then there is a final group, those who think that house prices are high enough and cannot rise much further (seemingly ignoring the lessons from the late 1980s) and who think that manufacturing will simply bounce back (thus hoping for a repeat of the post-Asian crisis rebound).

There are big problems with all of these interpretations. Each of them focuses on only one aspect of the UK's economy, or, alternatively, pretends that there is no real problem in the first place. These views, however, do not adequately capture the difficulty facing UK policy-makers. Much has been said about the UK's two-speed economy. Yet "two-speed" is no longer the most appropriate description. The UK is now a two-direction economy. It seems unlikely that this position can be sustained. From now on, the key issue is whether the economy eventually opts for forward or reverse gear.

At the root of all this, there is an underlying policy problem. The Bank of England is mandated to hit a fairly precise inflation target. Interest rates are the Bank's only weapon. And, as weapons go, interest rates are fairly imprecise, partly because they have bigger effects on some parts of the economy than on others.

The Bank may have reasonable control over the growth rate of GDP as a whole. The pattern of GDP growth, however, is beyond its control. The Bank has been powerless to do very much about the global manufacturing and technology collapse. After all, the experience of UK manufacturers in recent months has hardly been unique: the US, Japan, Germany and France have all felt the same chill winds. Meanwhile, the exchange rate has not quite responded in the appropriate way to falling interest rates. Although sterling is relatively soft against the dollar, it has remained very strong against a persistently disappointing euro.

To hit its inflation target, the Bank has had to manipulate the bits of the economy that are more easily controllable. That basically means the housing market and consumer spending. In other words, the housing boom is, in one sense, a direct consequence of the manufacturing bust. The Bank is obliged to maintain a steely indifference to these boom-and-bust developments, so long as there is no threat to the medium-term inflation objective.

This "indifference" raises some questions about the way in which the inflation target is defined. Does it make sense to increase the volatility of parts of the domestic economy in order to meet a precisely defined inflation target? Might it be better, for example, to allow greater room for manoeuvre on inflation in the light of global shocks, thus reducing the need for domestic economic volatility? Whatever the answer, in the meantime it is worth thinking about the degree to which this domestic/global trade-off can be resolved over the medium term.

In one sense, the conflict is not as big as it might appear. House prices have certainly risen rapidly in recent quarters but there is no immediate threat to the inflation target.

Why? Asset price inflation generally matters to the extent that it has a knock-on effect on spending decisions within the economy at large. In the late 1980s, house price inflation clearly did have this effect. Remortgaging to purchase consumer goods (known as equity withdrawal) increased dramatically and there was a major consumer boom. This time, the numbers offer no comparison. There has been only a modest pick-up in equity withdrawal. And the 2001 consumer has been only a very poor cousin of his or her 1980s counterpart. As yet, there is no real evidence to suggest that the UK consumer is about to push the economy into an inflationary spiral.

As far as the rest of the economy is concerned, the situation is still problematic. As I argued in last week's column, the global economy has been far weaker than most forecasters had expected a year ago and, as a result, the downside risks to the UK economy are greater than seemed likely back then. Of course, this doesn't prove that the UK is about to head into recession. It does, however, suggest that the bits of the economy that are beyond the Bank of England's direct sphere of influence are making the setting of monetary policy that much more complicated.

The current weakness of manufacturing does, however, suggest a possible resolution to the "forward/reverse" economy. Weaker corporate profits imply weaker corporate balance sheets, particularly in the new environment of relatively high corporate indebtedness (an observation not lost on the Bank of England, judging from last week's inflation report). Ultimately, this balance sheet threat is likely to imply greater cost-cutting and, with it, higher unemployment.

Job losses are never pleasant at the best of times. However, to the extent that they should help to reduce the risk appetite of the average UK consumer, some of the heat should be taken out of the housing market. This slow deflation should check consumer spending and, thus, pave the way for a less ambiguous approach to monetary policy. Under these circumstances, interest rates could fall more quickly with less fear of a sudden inflationary surge.

Having said all this, the rise in house prices still presents some potential difficulties for the future. One obvious reason for the rise in house prices is the reduction in borrowing costs in recent years. Debt service costs are now only a tiny fraction of what they used to be. Combined with a very competitive mortgage market, this has led to a significant increase in the "buying power" of the typical would-be house purchaser.

Unfortunately, however, there is more than a whiff of money illusion about this argument. True, debt service costs are a lot lower. But the actual debt is going to hang around people's necks for a lot longer now than used to be the case. Gone are the days when rapid inflation reduced the real value of debts. And going are the days when investments in the stock market were an easy way to pay off the debt with a rapid accumulation of financial assets. Consumers may not be feeling the pinch at the moment. But continued increases in house prices in the short term could lead to overly inflated household balance sheets over the medium term. That may not be a risk for inflation. However, it certainly provides a challenge both for credit quality and overall financial stability.

 

The writer is managing director of economics at HSBC.

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