Hamish McRae: We weren't ready to accept the truth that economic news would be so bad

Economic Outlook: Euro-watchers have been so focused on the nightmare of sovereign debt that the interest rate debate has faded into the background

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The Independent Online

Everything takes longer than you'd think. One of the many aspects of economics is the uncertainty of time-lags and that seems to be to be one of the central explanations for the dismal mood of the moment. We all knew that it would take several years to correct the UK fiscal deficit, with the only significant point of disagreement between various economists and indeed between the Government and the opposition being the pace: should one try and do this over four to five years or over six to seven?

But I don't think many of us were fully prepared for the sad truth that during this period most of the news would be so relentlessly negative. There is one particular bit of news which has until recently been very positive and there is another that is still positive. The first of those is the level of job creation in the private sector, which over the past year has been the fastest since the late 1990s; the second is that the government is able to borrow exceptionally cheaply, thereby slightly reducing the debt-service costs. But the rest of the stuff is glum: even allowing for the unreliable nature of the data being published, the fact remains that the slog seems somewhat harder than mostpeople expected.

You can react to this in two different ways. One is to call on policy-makers to do something; the other is to rely on the natural response to policies that are already in place and wait for them to work. There is huge political pressure on politicians to do the former. We will get an example of that this week with the new jobs plan from President Obama. Unemployment in the US is stuck at 9.1 per cent, a shocking level because that means that in many states the rate is in double figures.

It is true that this is very close to the average level in the eurozone, but in Europe the level of benefits is significantly better and indeed the high level in some countries, including the 20 per cent plus level in Spain, is partly a function of the level of benefits.

The simple point is that any particular level of unemployment in the US creates more pain than a similar level in Europe. Let's wait and see what the US President does before rushing to judgement and it may well be that there are useful things that can be done. There is certainly huge political pressure, given the figures last Friday showing no net growth in employment in the US. But let's also acknowledge that the impact of any measures is unlikely to have much of an immediate effect: the time-lags are too long.

The reliance on what might be called the self-healing features of economies seems a bit wet, conditioned as we are to politicians that claim they can fix things by some new "initiative" – as an aside, one of the things I find depressing is the way that lovely word has become so devalued in British politics. Sadly, the initiative-a-day characteristic of the previous government seems to have been continued by this one. But this week we are set to get at least two examples of the wait-and-see approach in what will almost certainly be no-change policies on interest rates both here and in the eurozone.

Euro-watchers have been so focused on the nightmare of sovereign indebtedness, a nightmare that will this month continue to disturb people far beyond the eurozone itself, that the interest-rate debate has faded to the background. As far as most people are concerned the key decisions from the European Central Bank are its continued willingness to accept dodgy sovereign debt as collateral, its liquidity support for the commercial banks in troubled eurozone countries, and its attitude to the creation of "Eurobonds", that is bonds that would be guaranteed by the eurozone countries as a whole, rather than being issued by individual sovereign states.

Had it not been for these more immediate issues the ECB might be finding itself taking some stick for its interest rate policy, having made two increases this year. Eurozone inflation, while above target (see first graph) is not far above it if you allow for the increase in prices that are the direct result of changes in direct taxation. If a government decides, say, to increase fuel duties, it is not intellectually correct to see that as a contributor to underlying inflation. Jefferies Fixed Income, which pulled together these charts, is concerned that the ECB is underestimating the impact of its interest rate increases on the weaker fringe countries and argues it should ignore the effect of direct tax changes on eurozone inflation.

So you might say that the ECB, by increasing rates relatively early has already taken appropriate measures to pull inflation back below the target ceiling of 2 per cent. (The ECB has 2 per cent as a ceiling, whereas the Bank of England has it as a central point of the target range.)

Others argue that the ECB may have made a mistake by tightening policy too early, by contrast to the Federal Reserve and the Bank of England, though frankly I find it a bit ridiculous to be debating about a quarter or a half percentage point either way. The plain fact is that nominal interest rates everywhere in the developed world are very low and if the economies are failing to grow as swiftly as people would like, it is not the fault of monetary policy. It is because the hangover from the borrowing binge is still throbbing away.

In any case the recovery for the eurozone as a whole is running a little ahead of that of the UK. As you can see from the other graph the profile is broadly similar but we are, at least on the figures as we know them, lagging a bit on Europe. The numbers for the UK show Bank of England estimates for output, which are a little higher than those of the Office for National Statistics.

A no-change decision from the Bank, both on interest rates and on further quantitative easing, is virtually certain this week. Nothing is likely to happen on interest rates for some months yet and if there were going to be any policy change on QE it would most probably be in November, when the next "Inflation Report" comes out.

So Britain continues with "wait-and-see" policies. The obvious question then is whether there is something to look for in the coming months that on the one hand might render such a policy unsustainable, or on the other shows that actually recovery is taking place under the radar but that the lags between policy action and economic effect are such that we cannot see it yet.

The main catalyst for a change in policy would be external and the principal candidate there is an even more serious twist to the sovereign debt crisis in the eurozone – something so serious that the real economy would be undermined. The main argument behind the wait-and-see approach is that once UK inflation starts to fall as it may well do quite suddenly next year, real incomes will be growing again and higher consumption will pull us back towards the previous peak in output by the end of 2012.

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