Don't rule out a rise in interest rates

There's every reason to believe economic growth will rebound solidly through the millennium

THE IMMEDIATE verdict of the financial markets on last week's Budget was that its headline-grabbing tax cuts have made another interest rate cut a little less likely. This may have been premature, and I think it is quite likely that rates will fall again, perhaps to 5 per cent, before the summer. However, looking beyond the short-term debate, fiscal policy may eventually contribute to a solid rebound in growth into the millennium.

As this becomes apparent, official interest rates may have to rise again, and possibly sharply. This possibility is not yet being seriously considered by the money markets, which currently envisage a smooth glide path towards eventual monetary union.

This week we may get the Bank of England's post-dated verdict. The Bank's Monetary Policy Committee was briefed on the broad shape of Gordon Brown's package before deciding, on 3 March, to leave interest rates unchanged - the first time that rates hadn't fallen at a monthly MPC meeting since September.

On Wednesday the minutes of the March meeting are released, and they may reveal whether the Budget was a material factor in the committee's decision. I doubt the Budget played a big role in the MPC's deliberations.

The net tax cuts that it contained were significant. They were also unexpected, and the Bank's economists are unlikely to have already incorporated them into their economic forecasts. However, the cuts were spread over three years, and focused sharply on 2001/02, with just pounds 1bn falling in 1999/00.

As a result, the Budget will have done little to alter the Bank's best guess at the likely rate of growth in the economy in the year ahead, and is unlikely to have shifted significantly the MPC's view as to the appropriate level of interest rates. Rates may have been left on hold for other reasons - such as the improvement in business surveys.

As yet, the official economic data have not fully reflected the weakness flagged by last year's surveys. It looks as if export deliveries in particular may have taken their long-feared tumble in the first quarter, and the latest data again show too many unsold goods sitting on manufacturers' and distributors' shelves for comfort. The economy still looks set to slow further in the first half of 1999.

Meanwhile, even us hardened inflation cynics concede that a long-awaited - and often-forecast - dip in RPIX inflation to below-target levels is likely soon. And the new average earnings data, which must surely be set in statistical stone for the time being at least, show pay growth trending steadily lower.

Alongside this prospective slowing in output and inflation, the pound is once again defying economic gravity and has pushed back above levels not seen since before interest rates began to fall. The currency has thus made no contribution to the loosening of monetary conditions seen since the autumn, yet the Bank has hinted that it would welcome one (and indeed, has been forecasting one). All this suggests that it is too soon to proclaim the trough in interest rates.

However, there are good reasons for thinking that the economy will begin to revive during the second half of the year, and that it will gather significant momentum as we move through 2000.

Perhaps most importantly, household finances are in solid shape. Aggregate wealth to income ratios are at an all-time high, and many consumers are experiencing a significant increase in their real spending power during 1999 thanks to low mortgage rates and continuing (albeit slowing) growth in pay.

For some years now I have been tracking the fortunes of a fictional consumer whose finances are reasonably representative of a moderately- geared borrower: in 1999, their real spending power will rise by roughly one-tenth, to a level more than half as high again as at the peak of the 1980s boom.

But another factor, which has been overlooked in last week's debate about the incremental impact of the Budget and its short-term impact on interest rates, is the underlying trend in fiscal stance.

The Chancellor argues that fiscal policy has been tightened significantly since the Government took office. There has certainly been a big improvement in the public sector accounts - a current deficit equivalent to 3 per cent of GDP in 1996/7 has been transformed into a surplus of 0.5 per cent in 1998/9.

The Treasury estimate that almost three-fifths of this turnaround has been generated by restraint on public spending, and that tax changes and economic growth have each contributed just over a fifth.

It is no surprise to find a Labour chancellor being tough on public spending. Of the three previous post-war chancellors who managed to cut real discretionary spending, two were Labour (Roy Jenkins and Dennis Healey).

However, Mr Brown is planning to take the brakes off. A significant increase in public spending from 1999/00 was announced last June - a profile which was reaffirmed in November, and again last week.

Having fallen slightly in the last two years, total managed expenditure is projected to grow by almost 3 per cent in real terms, on average, in the next two years.

If we exclude falling interest payments on the national debt, which may largely be saved or reinvested by their recipients, average real growth is close to 4 per cent. This could contribute roughly 0.6 per cent per annum to GDP growth.

The plans have long been known in outline, and so attracted little new attention last week. Much of the increase in spending takes the form of capital investment, and so is excluded from the projections of the widely-watched cyclically-adjusted Budget balances published in the Financial Statement and Budget Report.

Meanwhile, of the tax changes since 1996/97, perhaps half is accounted for by the abolition of tax credits on dividends. The bulk of this revenue will have been raised from pension funds, which were in rude financial health to begin with. Relatively few consumers were ever going to be asked to pay higher pension contributions as a result of these tax increases, and the tax is unlikely to have had much, if any, impact on aggregate demand.

Mr Brown's fiscal projections are plausible. He may even be underestimating the scale of the current Budget surplus to begin with, and the risk of a fiscal "black hole" re-emerging suddenly remains modest.

The medium-term rules according to which he is conducting fiscal policy are also as prudent as we could wish for. But the coming upturn in public spending, and the fact that consumers are not really feeling much of a tax squeeze on their incomes to begin with, represents another reason for believing that economic growth will rebound solidly through the millennium. And if it does, it will eventually take interest rates with it.

It is not the Bank of England's job to engineer a smooth glide-path into European monetary union, but simply to keep inflation risk under control. There have been two interest rate cycles since 1994: there is plenty of time for another.

Kevin Gardiner is a senior economist and executive director at Morgan Stanley Dean Witter. He is writing in a personal capacity.

Suggested Topics
Start your day with The Independent, sign up for daily news emails
ebooks
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Collections Agent

£14000 - £16000 per annum: Recruitment Genius: This company was established in...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE 40k: SThree: SThree are a global FTSE 250 busi...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + competitive: SThree: SThree are a global FTSE 250 ...

Reach Volunteering: Trustees with Finance, Fundraising and IT skills

Voluntary and unpaid, reasonable expenses reimbursable: Reach Volunteering: St...

Day In a Page

Isis profits from destruction of antiquities by selling relics to dealers - and then blowing up the buildings they come from to conceal the evidence of looting

How Isis profits from destruction of antiquities

Robert Fisk on the terrorist group's manipulation of the market to increase the price of artefacts
King Arthur: Legendary figure was real and lived most of his life in Strathclyde, academic claims

Academic claims King Arthur was real - and reveals where he lived

Dr Andrew Breeze says the legendary figure did exist – but was a general, not a king
10 best PS4 games

10 best PS4 games

Can’t wait for the new round of blockbusters due out this autumn? We played through last year’s offering
Migrant crisis: UN official Philippe Douste-Blazy reveals the harrowing sights he encountered among refugees arriving on Lampedusa

‘Can we really just turn away?’

Dead bodies, men drowning, women miscarrying – a senior UN figure on the horrors he has witnessed among migrants arriving on Lampedusa, and urges politicians not to underestimate our caring nature
Nine of Syria and Iraq's 10 world heritage sites are in danger as Isis ravages centuries of history

Nine of Syria and Iraq's 10 world heritage sites are in danger...

... and not just because of Isis vandalism
Girl on a Plane: An exclusive extract of the novelisation inspired by the 1970 Palestinian fighters hijack

Girl on a Plane

An exclusive extract of the novelisation inspired by the 1970 Palestinian fighters hijack
Why Frederick Forsyth's spying days could spell disaster for today's journalists

Why Frederick Forsyth's spying days could spell disaster for today's journalists

The author of 'The Day of the Jackal' has revealed he spied for MI6 while a foreign correspondent
Markus Persson: If being that rich is so bad, why not just give it all away?

That's a bit rich

The billionaire inventor of computer game Minecraft says he is bored, lonely and isolated by his vast wealth. If it’s that bad, says Simon Kelner, why not just give it all away?
Euro 2016: Chris Coleman on course to end half a century of hurt for Wales

Coleman on course to end half a century of hurt for Wales

Wales last qualified for major tournament in 1958 but after several near misses the current crop can book place at Euro 2016 and end all the indifference
Rugby World Cup 2015: The tournament's forgotten XV

Forgotten XV of the rugby World Cup

Now the squads are out, Chris Hewett picks a side of stars who missed the cut
A groundbreaking study of 'Britain's Atlantis' long buried at the bottom of the North Sea could revolutionise how we see our prehistoric past

Britain's Atlantis

Scientific study beneath North Sea could revolutionise how we see the past
The Queen has 'done and said nothing that anybody will remember,' says Starkey

The Queen has 'done and said nothing that anybody will remember'

David Starkey's assessment
Oliver Sacks said his life has been 'an enormous privilege and adventure'

'An enormous privilege and adventure'

Oliver Sacks writing about his life
'Gibraltar is British, and it is going to stay British forever'

'Gibraltar is British, and it is going to stay British forever'

The Rock's Chief Minister hits back at Spanish government's 'lies'
Britain is still addicted to 'dirty coal'

Britain still addicted to 'dirty' coal

Biggest energy suppliers are more dependent on fossil fuel than a decade ago