Diane Coyle: Why doomsayers have got it wrong over the economy

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The Independent Online

In fact, although the Bank has revised down its forecast for growth this year, the new Inflation Report is quite upbeat. Next year's forecast growth is revised up. Inflation will be a bit above target, but not by much, and will fall next year as growth is climbing.

This good cheer is emphatically not shared, despite the weather and our sporting success, by the pessimists at the British Retail Consortium. The retailers' trade organisation is at the forefront of those urging the MPC to cut interest rates again. The BRC's monthly press release has become a bit of a joke among those of us who monitor the economy, so depressed are retailers month after month, just like Eeyore, the gloomy donkey in the Winnie the Pooh stories. "Like-for-like" sales, their preferred measure which removes sales volumes due to new floor space, were down 1.9 per cent in the year to July, making it the weakest July since 1995. It would have been even worse but for the sunshine, they said.

However, an important reason for such weak "like-for-like" sales is continued over-expansion by retailers. What matters for the economy is growth in total sales volumes, which was 2 per cent in July. This is much weaker than in the recent past - nobody is arguing with the claim that there's been a marked slowdown on the high street. But when the long-term potential growth rate of the economy is 2.5 per cent, growth of 2 per cent in sales does not sound catastrophic. For several reasons, such as over-indebtedness among some consumers, and over-reliance of the economy on consumer spending, it will be no bad thing for us to stop shopping madly for a while.

British manufacturers can only dream of such strong growth in their output. They too would like to see interest rates reduced again. Manufacturing output has weakened, although the steep decline came in the first quarter of this year and output has edged higher in the past three months. But the level of production is the same as a year ago. British industry seems to be able to expand at a reasonable pace only when there is either a roaring economic boom, or a falling exchange rate, or preferably both.

So two important sectors of the economy are showing real signs of weakness, and this was reflected in the recent downward revisions to GDP. The Office for National Statistics (ONS) concluded that the economy grew more last year than they first thought, but has slowed more precipitously this year. The dramatic revision heavily influenced the four MPC members who voted for lower interest rates in July, and yesterday's Inflation Report shows that it decisively influenced the MPC's forecasts for growth and inflation.

So why doesn't all this make further rate cuts a no-brainer? Well, we mustn't allow the retailers to talk the rest of us into an Eeyore-like gloom. Even the latest GDP figures may be revised again: for the economy as a whole, output should add up to the same as expenditure, but so far the statisticians have found much less output than spending. The output measure is used in the inflation forecast (and hits the headlines); growth on the expenditure measure has slowed during 2005 too, but not by much. The ONS will revise one or the other.

In fact, there are plenty of indications that the economy is very far from a recessionary state. The global economy is growing strongly - indeed, US interest rates are going up as ours are going down, which is unusual. Share prices have been bubbling higher, and are back at the levels of late 2001. The exchange rate has depreciated (by 3.6 per cent in the latest quarter). Monetary growth has accelerated. The housing market has stabilised, and not crashed as so many doomsayers were predicting. Unemployment has risen slightly but the jobs market remains very healthy. Hence the Bank of England's new forecast shows growth accelerating soon, and back at about 3 per cent in 18 months. In the chart, taken from the Inflation Report and based on the assumption of no change in interest rates, the dark green band is the "central" forecast.

The Bank's forecast for inflation is similarly optimistic: assuming the oil price stops climbing, CPI inflation should peak around the end of this year, according to the Inflation Report. However, oil prices hit new nominal peaks this week, after the Bank's forecast was prepared. The second chart shows three separate inflation rates: the year-on-year increase in prices paid by manufacturers for the materials they use; prices charged by manufacturers for their products; and consumer prices. Each one is a smoother version of the last. When input costs are rising rapidly, as they are now, manufacturers take a lot of the pressure on their profit margins (and claw back a bigger profit margin when input costs fall again). So the prices they charge for their output do not rise nearly as much as the prices they have to pay. In the end, though, the higher costs are passed on.

The same process occurs at the next link in the chain: wholesalers and retailers absorb cost increases by reducing their profit margins, but in the end have to pass on an increase to consumers. As this process takes 12-18 months, there is already plenty of momentum in consumer price inflation. It is hard to see either manufacturers or retailers being able to accept still lower profit margins after more than a year of absorbing cost increases.

With consumer price inflation at its target, and the highest it has been since 1998, the MPC will have to be alert to these pressures even if there are still signs of weakness in the economy. If it is just changes in the growth rate which are driving trends in inflation, the MPC could respond to weaker growth with a rate cut without risking its inflation target. Most of the commentary about the outlook for interest rates assumes that growth is indeed the only thing affecting future inflation. But the MPC should respond to an external shock such as higher oil prices with higher interest rates regardless of the short-run impact on growth. The reason for having an inflation target rather than a growth target is exactly to ensure that monetary policy does the right thing in these circumstances, inflicting a modest amount of short-term pain to avert much greater long-term pain.

If you half agree with the MPC, and think that the economy is in good shape but that inflation pressures give more cause for concern, as I do, we will soon be talking about when interest rates will have to go up, and not whether they will fall again. But that too might be over-optimistic. Depending on how bad the oil price shock turns out to be, we could end up with higher inflation and weaker growth, and interest rates rising next year anyway. Now that would really give the retailers something to be gloomy about.

Diane Coyle is the founder of Enlightenment Economics

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