Don't rule out a rise in interest rates
There's every reason to believe economic growth will rebound solidly through the millennium
Monday 15 March 1999
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.
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