Hamish McRae: Bank and Treasury have little room to manoeuvre as downturn looms

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The Independent Online

You are not really supposed to say this, but I don't think it matters very much whether the Bank of England cuts interest rates today or not. The timing of interest-rate changes does affect the financial markets and maybe in the short term the housing market, too. But the big issue is not whether or when rates move but rather the monetary and fiscal room the UK authorities have to offset a downturn. Unfortunately, they do not have as much space to manoeuvre as the Bank and the Treasury would like.

The point here is simply that neither monetary nor fiscal policy operates in a vacuum. There are limits on both. Both have to be credible to financial markets and, while it may take some time for errors in policy to show up, sooner or later such errors are punished. Thus the sub-prime crisis in the US is the punishment for an excessively lax interest rate policy three or four years ago. The squeeze on UK public sector pay now (of which more in a moment) is the punishment for the excessive increases in the public sector headcount two to five years ago.

This week the Bank does have room to cut interest rates by a quarter point; I don't think it would receive any significant criticism for that. But whether it can really cut rates sufficiently to offset a housing slump is quite another matter. What it has to avoid is cutting rates too fast this year, only to support a bout of inflation and then have to increase rates next year when the economy is still weak.

You can see one of the constraints on the Bank in the first graph: inflation. While it is true that the official measure of inflation, the harmonised European index that we adopted and have renamed the Consumer Price Index, has been behaving itself, the familiar Retail Price Index has not. The two have diverged dramatically, with the CPI close to the 2 per cent central rate, but the RPI stuck at over 4 per cent.

The RPI will come down a little if the decline in mortgage rates is not offset by rising fuel and other costs, but that high level of inflation is damaging public finances as benefits, public sector pensions and the interest in index-linked government debt are all tied to it. Indeed I do not know of any significant public sector financial agreement that links to the CPI rather than the RPI. Technically, the Bank of England is required to target the CPI but it has little practical significance in the national economy.

This high level of inflation is one of the reasons why public finances have, as Robbie Burns would have put it, gang agley. You can see that in the next graph. Each month this financial year the Government's deficit has been greater than the previous year, even though it was supposed to be less. Conceivably there will be some sudden improvement in the remaining time to end-March, but no one really expects that to happen. With the prospect of slower growth this year and hence lower tax revenues, it is hard to see the deficit coming down in the coming financial year either.

That explains the pressure on public sector pay. The Government headcount has been coming down now for about 18 months but that follows a string of increases. The Government cannot realistically hope to reduce its number of employees any faster than it is at the moment, so it has to find some way of holding pay increases below inflation. It has tried to use the 2 per cent CPI figure as a benchmark, but if you look at the next graph you can see why that is not credible.

Wages in the economy as a whole have been rising at between 4 and 6 per cent in money terms for the past six or seven years, equivalent to between 1 and 3 per cent in real terms (using the RPI). Were the Government to make a 2 per cent increase stick, that would result in a fall in real earnings (based on the current RPI) of more than 2 per cent. No one knows what will happen to the RPI over the next three years, but, even if it were to come back to 2 per cent, public sector employees would have no increase in their real wages for three years. You might argue that many have better pensions than those available in the private sector, shorter hours and greater job security, but it is still tough to impose a cut in real pay. Yet that is what the Government feels it has to do.

So we have clear limits on both monetary and fiscal policy. There is certainly some scope to cut interest rates but there is very little scope, if any, for a laxer fiscal stance. And there is a further concern: might sterling fall sharply, rather as the dollar has done, putting more pressure on inflation?

Like most people, I had not noticed until recently quite how seriously our balance of payments current account had deteriorated in recent months. Back in 1997, the current account was just about in balance: it was a deficit of 0.1 per cent of GDP. In recent years, it has been steady at around 2-2.5 per cent of GDP. Given good growth and some inward investment, that should be acceptable. Now suddenly things have become much worse, as a couple of independent British economists have recently pointed out. Ruth Lea, former economic adviser at the institute of Directors and now at Arbuthnot Banking Group, reckons the deficit last year has shot up to 5 per cent of GDP and that the pound is vulnerable.

This is echoed by Andrew Smithers at Smithers & Co, who thinks that the deficit may be understated and could even be 7 per cent of GDP. It is a plain fact that in the third quarter of last year the UK had a larger current account deficit even than the US. At any rate, the deterioration is pretty stunning, as the final graph demonstrates. Since the UK has the highest short-term interest rates among the large economies and therefore has the greatest scope for reduction, he argues that sterling is most exposed to a downturn in the world economy.

A fall in sterling would not be all bad. It might be good for the stock market and it would certainly be good for exporters. Indeed some decline in the pound is necessary to correct the current account imbalance. It also gives a more general boost to the economy. The Bank used to have a rule of thumb that a 4 per cent change in the exchange rate was roughly equivalent to a 1 per cent change in interest rates. But any decline would increase the price of imports, as it is already doing, and hence will feed through into inflation. I think we have to recognise this is a real possibility.

Whether or not the Bank moves today, it is widely expected to carry on cutting rates through this year. That may well turn out to be right. But monetary policy alone cannot rescue an over-borrowed economy, or indeed high-street retailers such as M&S.

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