Jeremy Warner's Outlook: Productivity gain makes case for lower rates

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Interest rates were left on hold by the Bank of England yesterday, but the general assumption in the City is that there is at least one more rate rise to come before we hit the top of the present cycle. The only question in the minds of most analysts is whether this will come before or after the election.

Interest rates were left on hold by the Bank of England yesterday, but the general assumption in the City is that there is at least one more rate rise to come before we hit the top of the present cycle. The only question in the minds of most analysts is whether this will come before or after the election.

There's good reason for remaining hawkish. Energy prices seem to reach new peaks almost daily, and so does the cost of most raw materials. There are also signs that relentless deflation in the price of goods may finally be drawing to a close.

What's more, wage settlements have been edging higher. At 4.5 per cent, the year-on-year increase in earnings last month was already at the maximum the Monetary Policy Committee believes compatible with its inflation target. Anything higher, and wage inflation could be expected to trigger a more general price inflation. With big labour shortages developing in key areas of the economy, this looks only too likely.

Yet the more interesting case to argue is the one against the need for any further rise in rates. Indeed, there may even be a case for lower rates. The argument rests less with the present slowdown in consumption and house price inflation - though these are indeed cause for concern - than the possibility that finally, after all these years, the British economy may at last be showing some big improvements in productivity.

The most recent data points to considerable gains, and though it would be wrong to extrapolate from such short-lived experience, there is good cause for optimism. As you might expect, the recent gains are more marked in the private sector than the public, where the improvement is still little more than trend.

The Government has tried its hardest to introduce market-style incentives into the public sector, but most of the evidence is that it's not working. Lord Browne, chief executive of BP, recently dismissed these mechanisms as "pseudo markets", for the monetary incentive for improvement, innovation and efficiency that exists in the private sector can never be properly replicated in tax-funded endeavour, where there is a set rate of pay for a particular set of services provided.

But try as he has, the Chancellor hasn't yet wholly crowded out the private sector, where big IT and supply chain led leaps in productivity are now being achieved. At the time of the last Inflation Report last month, Mervyn King, Governor of the Bank of England, warned of the dangers of jumping to conclusions.

You would expect big gains in productivity at this stage in the cycle, since there is a lag between the cost cuts achieved by business during the downdraft of the economic cycle and the present recovery in revenues. Businesses are still getting by on their recession-adjusted cost bases. It is only when they become confident that revenue recovery is here to stay that they start to take on more cost and investment again.

So the big question is whether the present strong rate of productivity growth is any more than cyclical. My own soundings among business leaders suggest strongly that it is. Famous last words, but CEOs seem genuinely more disciplined than they have been in past cycles in keeping the lid on costs. They are also under huge pressure to do so, and not just because of new competition from the developing economies of China and India.

The capital markets are also much more demanding than they were. Companies that engage in risky spending and wasteful investment get severely punished. In combination with big IT and supply chain improvements, all this points to a step change in levels of productivity growth. And if that's the case, then interest rates can afford to be lower, perhaps a lot lower, for a given level of growth than they have been in the past.

Mobile phone wars

Let battle commence. No sooner had Stelios Haji-Ioannou launched his latest discount business venture,, than he was undercut by Carphone Warehouse's Charles Dunstone. The price war thus declared has all the elements of a good novel, for it pitches two of Britain's most successful young entrepreneurs against each other in an apparent battle to the death. It also presages a new phase, if that's the right description for such a fast changing industry, in the development of mobile telephony.

Fast back to the mid-1980s, when the first mobile phone licences were issued and the technology was so stone age that you virtually needed a suitcase to carry the handsets and related battery charger around. Few believed mobile phones could ever be more than an expensive executive toy, so when Vodafone (or Racal as it then was) based its business plan on a projected market of up to 100,000 subscribers, it was almost laughed out of court.

The rest, as they say is history, but in achieving more than 100 per cent penetration of European markets (some people have more than one mobile), the big market driver was handset subsidy. This has been the model for customer acquisition ever since, involving the mobile phone operators in huge upfront investment. You may think you are getting the handset for free, but the idea is that the costs are eventually recovered through call charges. This is still largely the case today. Sign on for a new contract, or pre-pay deal, and you are likely to be offered a "free" mobile phone as part of the package. With penetration at more than 100 per cent, the handset subsidy model becomes less sustainable.

Many subscribers aspire to nothing more than a voice only, value for money service. They are not interested in the latest mobile handsets, or the bewildering array of extra services the operators want to sell to their subscribers. It is this market that both Stelios and Mr Dunstone, with his existing Fresh, virtual mobile phone network, plan to tap into. Both sell just the Sim card on the assumption that the subscriber already has his/her own handset, or is prepared to buy a new one outright. Where the existing handset is locked into a rival network - a ploy used by some to prevent switching - it can easily be unlocked.

What both Stelios and Mr Dunstone are doing is separating for the first time the cost of the handset from the cost of the service, at least for pre-pay deals, which are still the largest part of the market by number. Carphone meanwhile continues its steady transformation from retailer of other operators' services to a fully fledged telecoms operator itself.

More puzzling is why the established mobile operators are prepared to allow these virtual networks to piggie back off their own, given that they cannibalise existing mobile subscribers. It is perhaps no coincidence that the two companies most prepared to do these deals are T-Mobile and O 2, who as the smallest of the big four perhaps figure they don't have as much to lose. Wholesale revenue is better than no revenue at all. As T-Mobile's chief executive, Rene Obermann, has observed, the pre-pay subsidy is dead; only the funeral has to take place.


For a change, shareholders can congratulate themselves on a job well done. It appears they did the right thing in turning down Hugh Osmond's private equity style bid for Six Continents nearly two years ago and instead opting for a straight demerger of the pubs to hotels group. Both halves of the group, InterContinental and Mitchells & Butlers, have done fantastically well since then.

But perhaps the most striking transformation has been InterContinental, whose share price has nearly doubled. InterContinental has always been more of a franchise and management operation than an outright hotel owner, and with yesterday's sale of a further 73 UK hotels to a consortium of buyers, it becomes almost wholly so. By so doing, there's another £1bn to be returned to shareholders, bringing to £2bn the total capital repayment since the demerger. No wonder Mr Osmond was so keen to buy.