Economics: An early rate cut may prove politic

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The Independent Online
THE CHANCELLOR has the right idea about the time of year. He has taken his wife, special adviser, permanent secretary and private secretary off to the hot climes of the Philippines, Indonesia and Hong Kong until 11 January, a near two-week break billed by the Treasury as a fact-finding and trade promotion mission in these key emerging economies.

Only on the 12th will Kenneth Clarke - tanned and relaxed, I trust - turn his attention once again to the travails of the British economy, when he meets Eddie George, the Governor of the Bank of England, to discuss interest rates. The clever inside money is that these two - Mr Clarke and Mr George - have different but converging reasons not to cut interest rates. They will go, some insiders say, as slowly as they can. Do not hold your breath.

The argument about Mr George is very simple. We have it on his own authority that he is not an inflation nutter, but he is certainly not an inflation enthusiast either. The Bank is very happy with underlying inflation at the 2.5 per cent mid-point of the Government's target range, but would be even happier if it were lower. Whatever the inflation rate, the Bank will always have a worry or three about how it might creep up. Such is the ghost - or perhaps the poltergeist - of the inter-war governor, Montagu Norman.

Mr Clarke's interests are more complex. He is bored and sometimes perplexed by economics, but he certainly has views about politics, and he apparently believes that there is little present political advantage in cutting interest rates. This is partly because he is reassured by his new friend Mr George and others that the recovery is proceeding happily. And it is partly because he is afraid that excessive enthusiasm in cutting interest rates may mean that he has to raise them again, an altogether less appealing proposition.

Indeed, the bond markets, which are currently running away with themselves over the prospect of low inflation as far as the eye can see, should remember that the real long-run risk is not economic, but political. Mr Clarke has been tough about taxes and public spending, because an early political nemesis threatened him if he was not. But Mr Clarke's toughness remains to be tested on monetary policy.

This Chancellor has never raised interest rates. Nor did his predecessor, Norman Lamont, ever raise interest rates (since I will not allow the brief two percentage point rise announced on Black Wednesday). Nor did John Major, Mr Lamont's predecessor as Chancellor, ever raise interest rates. His officials recommended that he do so, but he funked it. The last British Chancellor to have raised interest rates was Lord Lawson in 1989. So there is no senior politician in the British Government who has ever carried the can for a rate rise.

Since a cut in interest rates now would make a rise in interest rates more likely in future - what goes down, comes up - the clever inside view is that further interest-rate cuts will probably only happen in response to a strong rise in sterling, or to a weakening in the recovery. These sceptics think the financial markets are now getting ahead of themselves in expecting an early cut. So will it really happen?

Take sterling first. As the graph of the trade-weighted index shows, the pound has been remarkably and suspiciously stable recently, despite a narrowing of the difference between German and UK interest rates, which would normally have pushed up the pound quite sharply. In fact, the pound has risen against the mark, but the dollar has risen even more. So the pound has been treading water overall.

This is not, though, entirely adventitious. Although the Bank and the Treasury deny that there is any policy to target the exchange rate, their actions have, in effect, done just that. They have happily sold sterling in order to buy foreign currency with which to repay the borrowings incurred defending the pound in 1992. The short-term borrowings, which were substantial but which have never been revealed, have been repaid. The Treasury announced just before Christmas that it had also repaid a 5bn ecu ( pounds 3.8bn) facility.

What if the pressure on the pound continues to mount? Despite the official selling, the pound closed last week at its highest level since Black Wednesday. And the pressure may go on, not least because the famous Japanese wall of money may be about to take over from the US wall of money as a support for European markets. A high yen, a depressed economy, and negligible short-term interest rates all add up to a strong case for the Japanese fund manager to go travelling in search of reasonable yields. As he does so (and the graph shows some tentative evidence in the most recent half), both sterling and UK bond and equity markets are likely to prove particular beneficiaries.

The Chancellor is a Midlands man, who will not want to see sterling appreciate strongly, if at all, because he has the interests of industry at heart. So he will sell more pounds and rebuild the reserves. He may also be forced into interest-rate cuts, but these will be determined by outside forces rather than by developments in the British economy. The likely strength of sterling is one reason why I expect interest rates to continue falling, perhaps as low as 4 per cent this year (giving a mortgage rate of 6- 6.5 per cent).

Timing is always difficult with the foreign exchange market, but I hope that these events take place sooner rather than later because I am much less sanguine than the Treasury or the Bank about the health of the recovery. Mr George recently said that he thought the economy was growing in line with its potential, but this still leaves the gap between actual and potential output at the highest level since the recession began. Output must grow by more than 2.25 per cent a year if the gap is to close.

Indeed, it is even doubtful whether the gap is stable. Since Mr George's remarks, the figures for gross domestic product in the third quarter show that non-oil growth over the year ran at just 1.6 per cent. This is so far short of potential that even the CSO's revision- prone statisticians are unlikely to alter the picture too much. The economy is growing, but it is growing too slowly to sustain the fall in unemployment or the rise in spare capacity.

Moreover, the economy is about to be mugged by the Government's substantial rise in taxes. Although the impact of frozen personal allowances and of the cut in mortgage relief only builds up with time, employees will face an immediate one percentage point rise in employees' National Insurance contributions in April, together with the rise in VAT on fuel and other imposts. The Chancellor must be ready to offset the impact, or he will find that the economy pauses over the summer.

The joy of interest rates, of course, is that they can be changed at any time. In theory, the Chancellor could wait for clear signs of a slowdown and then cut interest rates again, maybe not until just before the local government elections in May and the European elections in June. But he will run serious risks if he adopts such a wait-and-see strategy, because so many mortgage payments are in fact fixed just once a year.

About 40 per cent of the 8.2 million outstanding mortgages are on annual review, which means that their payments are fixed at the appropriate level, usually between December and March, and held there for a year.

The Halifax will set 1.2 million mortgage payments for a year from April on the basis of January's interest rates.

In other words, the Chancellor does not have the option of waiting and seeing. He has to make a judgement about the impact of tax increases now.

That is, of course, a rather economic argument for a rate cut. But there is also a political one. If Mr Clarke gets his judgement wrong, failing to cut interest rates soon enough to offset the fiscal tightening in the spring, he is likely to be blamed for any slowdown in the economy at around the time of the May-June elections.

Far from removing Mr Major from the premiership, the poor election results may merely torpedo the chances of the heir apparent. Perhaps the clever insiders are wrong, and that rate cut will come sooner after all.

(Graphs omitted)

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