Hamish McRae: Bid farewell to the high life

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The Independent Online

This joyful Eastertide is a sight more joyful than most people expected three months ago.

This joyful Eastertide is a sight more joyful than most people expected three months ago. The holiday weekend is always the busiest period of the year for two activities, DIY shopping and travel. It seems that if we do not want to spend our money on going away, we spend it instead on staying at home. But the doubts and worries that plagued much of the world through last year, and particularly through the winter, might have taken the gloss off this weekend. The world economy is only in early recovery stage, and political uncertainties still abound.

However, as anyone who has tried to go through an airport in the past month will testify, travel now seems to have recovered fully. The planes across the Atlantic are full again; British Airways has restored most of the flights it cut; and within Europe (though not the US) passenger movements though airports have recovered to pre-11 September levels. On a year-on-year basis they are now back to the same level as 12 months earlier, as the left-hand graph above shows.

As for British retailing, there was a slight pause post-Christmas but the very latest signs are that trade has picked up again. DIY is a specialist corner of the retail trade but anecdotally it seems likely that this Easter will be decently up on a year ago. The determined "don't talk to me about recession" buying by British consumers through the last two years (see middle graph), notwithstanding the recession in manufacturing, kept growth inching forward. (The latest official figures for the final three months of 2001 show activity was flat, but expect these eventually to be revised upwards.)

But statistics are rear-view mirror stuff. As you traipse around Ikea, slope off to the slopes, or house-hunt (that other favourite long-weekend activity), what should you be thinking about the prospects for the economy through the rest of the year?

The big theme, I suggest, will be the tension between the recovery, on the one hand, and rising inflation and rising interest rates on the other. We can now see that the central banks, by pumping vast amounts of liquidity into world markets last year, supported house prices, particularly in the US and UK, and encouraged a surge in consumer borrowing. Continued strong consumer demand kept the US and UK economies going through the winter. But now it is pay-back time, or rather claw-back time, for the central banks will have to claw back some of the liquidity they have created if this is not to lead to inflation.

You can see the way in which the growth of money supply in the developed world has diverged from the growth of GDP in the graph on the right. Monetary policy is an inexact science at best, but the divergence is so remarkable that you would expect two things to happen. One would be a strong global economic recovery, and bear in mind that Merrill Lynch, which drew attention to this phenomenon, thinks the global economy could soon be back to 4 per cent annual growth. The other is rising pressure on inflation.

Inflation? Surely not: the prices in the shops are either stable or falling, and items such as air fares have never been lower in real terms. But while the lags between monetary growth and inflation are uncertain, at some stage more money is likely to translate into higher prices. It has in the property market, and in the case of the US, and to a lesser extent the UK, it may be that we have only escaped the pressure of rising prices because of the safety valve of low-priced imports. That happened here in the late 1980s, when the authorities were misled by the apparently low inflation figures and tightened policy too late. It transpired that the good inflation figures were only good because the strong pound was encouraging a surge of imports and masking the true inflationary pressure in the economy.

In any case, there is no doubt that the global interest-rate cycle has bottomed. The first rises from Sweden and New Zealand have already come through, and we will get the first US and UK increases in the next couple of months. The rate at which our rates rise is still to play for: much will depend on the Budget, and particularly how it is received, now only a couple of weeks away. If it appears to be overly expansionist, with the Chancellor not increasing taxes enough to pay for his additional spending, then rates will go up faster. So we will be clobbered either way. It is certain we will have some rise in taxes and some rise in interest rates. The issue is the balance between the two.

We are not going to like this. Through the 1990s British consumers became accustomed to rises in living standards of, on average, close to 4 per cent a year. But the economy is growing at an average of about 2.5 per cent a year. In the short term, the strong consumer growth has been very helpful in keeping the recessionary wolf away from the door. In the longer term it cannot continue and will have to revert to the same rate of growth as the economy as a whole.

Actually it is worse than that. The share of output being consumed may have to fall a little, as resources are switched to public spending. Politicians are reluctant to spell it out but more money for public services means that private living standards will have to grow not only more slowly than they have in the past but more slowly than the growth of the economy. So this Easter may mark the end of an era: a long period when living standards on average rose very quickly – not for everyone, of course, but for the country in general. The prospects for sustained decent economic growth are as good as ever. But we won't be able to enjoy the fruits of that growth quite as much as we have in the past.