Beware the boom

It might seem absurdly early to say it, but everyone - business people, investors, house buyers, savers, even Treasury mandarins - should start asking themselves about the way in which the coming boom will need to be checked. This might seem an abstruse, theoretical question, for even with above-trend growth, say of 3.5 per cent, it will be four or five years before the economy will run into serious capacity restraints. But now that the recovery is reasonably secure it is very important that the growth phase is managed properly, and the action that ordinary people take in their personal or business finances should depend on their judgement of the authorities' ability not to make a mess of things.

How will we know? First, a short- term issue, and then a longer-term one. The short-term question is a very practical one: will the next change in interest rates be up or down? Until a few weeks ago the consensus would have been that it would be down, on the grounds that not enough had been done to pump up the recovery and that, in as far as these things matter with sterling out of the ERM, there would be more scope for a fall were the Bundesbank to cut its own rates still further. But now the mood has shifted. The mainline view at present is that there is neither the need nor the scope for a further fall as far as the home economy is concerned. The only argument would be that a surge in sterling might need to be resisted, and that the intervention to do that might need to be supported by a token cut in interest rates.

The shift in judgement in recent weeks has been caused by three factors. One is the signs that the recovery started in the spring of last year before sterling was forced out of the ERM, but that it took some nine months, and the events of Black Wednesday, before it took hold. So we have really had a year's recovery already, even though it hasn't felt like it. (As the 1992 figures are revised, expect the statisticians to discover more growth for last year.)

A second is the bound in business confidence. That has shown through in a number of ways, but the most reliable indicator is the CBI's industrial trends survey. This has, historically, been a very good indicator of company profitability a year ahead. The fact that company chiefs are more confident than they have been for a decade suggests that earnings will be very strong in 1994. So not only has the economy been rising for longer than previously thought, but companies are benefiting from it. The optimism may also be associated with the earlier-then-expected falls in unemployment.

Third, house prices have started to rise again. It is, naturally, toe-in-the water stuff, and the very small recovery may not be sustained. But a rise, even a small one, is better than a fall and, if only as a measure of confidence, it must be worth something. Taken together these new pieces of information have convinced the financial markets that no further cut in interest rates is really necessary.

Unnecessary maybe, but dangerous? The danger shows best in the gilt market. The Government is finding it difficult to sell enough gilts to cover its budget deficit. It always anticipated some such difficulties, but this week these have become quite serious, for while at a price it can always sell the stock, a rise in gilt prices would show how worried financial markets were about the Government's policies. The market is worrying about the size of the PSBR, about the danger of inflation rising above 4 per cent later this year, about public spending and about the trade deficit.

Were the authorities to ignore these worries and make more than a token cut in rates, they would, in the judgement of the markets, be setting themselves up for a runaway, and hence unsustainable, boom in 1995 and 1996. They would also be failing to start the structural transformation that most sane economists believe is necessary: cutting the share of consumption in GDP by about 5 per cent. The twin deficits are unsustainable in the long term. So we have to have several years of consumption growing more slowly than GDP. This means shaving the froth off the next boom.

Some such shaving will start next year, as the tax measures announced in the Budget start to come into effect. But meanwhile the authorities need to start leaning against inflation. Those cheerful CBI businessmen were cheerful partly because for the first time in nearly two years more of them were increasing their prices than cutting them. NatWest Capital Markets now forecasts that underlying inflation will reach 4.4 per cent by the end of next year and help push base rates to 7 per cent.

The next move in base rates will be a test. If it is down, the working assumption should be that there will be a modest inflationary binge in two to three years' time, and the country will be back to a milder version of its old stop-go. If on the other hand it is up, perhaps some time this autumn, then the authorities really will have learnt the lesson.