'If official interest rates were to remain unchanged over the next two years, then it is probable that inflation would gradually rise to a level above the mid-point of the target range,' it murmured. The target range for underlying inflation is 1-4 per cent, and the Government aims to be below 2.5 per cent in the spring of 1997. So if the Government wants to hit its long-term target, rates will have to rise.
As not even the daffiest inflation optimist believes that official interest rates will stay unchanged for the next two years, this hardly ranks as one of history's most spine-chilling warnings. The short-sterling futures contract is, after all, predicting a 1.5 percentage point rise in base rates in the next four months alone. It is difficult to justify this degree of pessimism on the basis of the Bank's forecasts, let alone the political instincts of the Chancellor of the Exchequer.
The Bank's relatively sanguine tone confirmed that the money markets need not have panicked on the previous Friday about the prospect of an imminent base rate rise. This frenzy of speculation had been stirred up when the Bank accepted tenders for 91-day Treasury bills at 5.75 per cent, up from 5 per cent a week earlier. The Treasury bill tender enables the Bank to borrow on the Government's behalf for short periods. It has almost never been used to signal base rate changes, but on this occasion even the most experienced market operators were badly spooked.
The Bank affects to have little sympathy for those who lost money in the melee. But it should be concerned none the less. The fact that its actions can be misinterpreted so comprehensively surely says something about its communication with the markets. There is even talk that some overseas central banks were so appalled by the Bank's cackhandedness that they are now demanding an extra risk premium to hold gilts as part of their foreign exchange reserves.
But the flurry did have one positive result - long-dated gilts jumped when it looked as though base rates might be on the way up. This suggests that the markets would react more favourably to a pre-emptive rise in rates here than they did when the US Federal Reserve first raised its rates six months ago. The Fed's move triggered a sharp fall in share and bond prices, because dealers feared it was reacting to some bad news they did not yet know about.
The favourable reaction to the base rate speculation also demonstrates that the Bank cannot afford to wait too long before tightening if it wishes to appear decisive and foresighted. Remember that eight of the last nine periods of rising interest rates were triggered only when the Government was forced to act by a falling pound. And, the aberration of Black Wednesday aside, the last five years have been the longest period without a rise in base rates for half a century.
So what about the timing? Subjecting reports written by committee to detailed scrutiny can be misleading. But a couple of clues emerge. First, the Bank goes along with the consensus that interest rate changes take about two years to have their full effect on inflation. This implies that the last possible date on which the Bank could expect to restrain inflation by the end of the Parliament by raising rates would be spring next year.
Secondly, the report warns: 'The pressures for higher inflation in the future may be building up even as the published inflation rate for the past continues to fall.' As the Bank expects underlying inflation to fall for at most another quarter, this suggests it may urge a rate rise within that period.
City economists have spent the past few days poring over their year planners to work out at which of their monthly meetings Kenneth Clarke and Eddie George will finally bite the bullet. The Bank may press for early autumn, but this would be uncomfortably close to the Conservative Party conference. A rise in November is perhaps most likely, as part of a package with the Budget. But some optimists believe inflation will still be low enough for the Chancellor credibly to reject the Governor's advice until next year.
In its heart of hearts, the Bank may well feel that rates should have risen already. But it may be waiting for evidence that neither the tax increases nor the weakness of the housing market are likely to cause recovery to stall before it presses its case. To raise rates shortly before a pause in growth would do its reputation and hopes of independence no good at all.
But the authorities should have the courage to act early. The Bank was more realistic in last week's report than in its predecessors about the benign outlook for inflation over the next few months. This is no bad thing, as it has been overly pessimistic about the short-term outlook for inflation in its last three reports. However, it is probably still too optimistic in its forecast of inflation two years hence.
Why worry now, given that the economy has only grown at above its long-term sustainable rate for one quarter? It is important to remember that the Central Statistical Office usually underestimates the pace of growth at this stage of the recovery. This means that the economy may soon be expanding at an annual rate of 4 per cent.
A great many spreadsheet print-outs have been produced in attempts to measure the economy's spare capacity, but on most realistic calculations, growth this strong cannot be sustained for long. The Confederation of British Industry's capacity utilisation measure is above its long-term average, and the Chartered Institute of Purchasing and Supply is already reporting that some parts of industry are having difficulty keeping pace with demand.
The weakness of the housing market is perhaps the strongest argument for delaying a rise in interest rates. House prices are subdued, transactions are down after adjusting for seasonal effects, and figures last week showed that mortgage lending was flat in June.
This is no bad thing. A report by Peter Westaway, of the National Institute of Economic and Social Research, warned last week that even a fairly modest revival in the housing market would provide an uncomfortably large injection into consumer spending, as people spent cash they had raised as part of a mortgage. He predicted that mortgage equity withdrawal could add 2.5 per cent to consumer spending by the end of the decade if house prices grow in line with incomes and the level of transactions returns to normal. Most people still believe that home ownership is their ideal form of tenure, despite the boom and bust of recent years. So the longer we have to wait for a take-off in the housing market, the better.
The debate on interest rates has so far been preoccupied with timing, but the size of any increase is just as important. Economists differ widely in their estimates of the effect of a given change in rates, often because they are unsure what effect it will have on the pound (and therefore import costs) and the pace of wage increases. For example, the computer model used by the National Institute finds that a 1 point rise in rates cuts the average level of prices by 2.3 per cent in two years, while raising unemployment by 13,000. But the Treasury's model finds that it would raise prices by 0.5 per cent and increase unemployment by as much as 80,000.
These uncertainties make it all the more difficult to know when and by how much rates have to be changed to hit a given inflation target. The phraseology of the Bank's report suggests that inflation is on course just to edge above its target level. So a small nudge on base rates should be enough to pull it below. But raising rates by a quarter or half a point will not be enough. If you are in a car, heading for a brick wall, it is not enough to reduce the pressure on the accelerator. Eventually you have to take your foot off the pedal entirely and hit the brake. The quicker you act, the less violent the movement needs to be.
The Fed has couched its interest rate policy in terms of reaching 'neutrality'; a point at which it is pressing on neither the accelerator nor the brake. The Bank should do the same. A 'neutral' interest rate here would be perhaps 7 per cent, although the uncertainties described above mean that this estimate is subject to a big margin of error. Despite the growth of fixed-rate mortgages, Adrian Cooper of James Capel calculates that the impact of base rate changes on personal incomes is still greater than at any time before 1988.
Economists might pretend otherwise, but the art of interest rate policy has always been more one of broad brush-strokes than fine line drawing. Acting early does not guarantee accuracy, but at least it gives the authorities more time to rectify their mistakes.
(Graphs omitted)Reuse content