Economics: Bank of England has not done enough

Gavin Davies On Why Monetary Policy Should Be Tightened
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The Bank of England Monetary Policy Committee took its first difficult decision last week when it raised interest rates by 0.25 per cent in the face of stock market turbulence and a rising exchange rate. Despite criticism, the move was overdue. In fact, the freeze in base rates announced in August was a mistake.

Here are seven key points that describe the policy dilemma today.

First, there has been no sign that the recent break-neck growth in the economy is slowing down. Ever since this time last year, the economy has been expanding, on the official GDP statistics, at a rate of 1 per cent per quarter, or 4 per cent per annum. This rate may have stopped accelerating during the summer, but it is almost double the rate of growth which can be safely sustained in the UK economy over any lengthy period.

Second, the economy is now running out of spare capacity. It is one thing for GDP to grow rapidly at a time when there are plenty of spare resources - machinery and people - standing idle in the UK. It is quite another for the growth rate to exceed its normal pace at a time when spare resources are limited. That is the case at present. The graph shows what would have happened to GDP if it had grown at its normal trend rate of 2.3 per cent per year during the 1990s. Four years ago, the published level of GDP was around 5 per cent below this trend, so there was plenty of scope for a safe period of rapid growth. Now, however, the published GDP number has returned almost exactly to trend. And, more important, we must never forget that subsequent data revisions are likely to be in an upwards direction. The genuine level of GDP is therefore already above trend, suggesting that resources are under strain.

Third, this conclusion is supported by business surveys. The CBI series on capacity utilisation has been substantially above its mid-cycle level for more than two years. More worrying, there has been a sharp increase in the number of firms reporting a shortage of skilled labour. Again, this shows up clearly in the CBI survey. In the past, such sharp increases have been a worrying sign for the monetary authorities. Around 17 per cent of all firms are reporting skilled labour shortages, a figure last seen during 1987. And the trend is very rapidly upwards, as it also was during 1987. In 1987, these and other labour market signals should have induced the monetary authorities to raise interest rates. They create a strong presumption in the same direction now.

Fourth, it must be admitted that there are factors pointing in the other direction, and which suggest the economy may well slow of its own accord during 1998. The most important restraining factor is the strength of sterling and the impact this is having on export orders. According to the CBI survey, export optimism has dipped to levels only previously plumbed during the depths of the ERM crisis and during the early years of Margaret Thatcher's government. Although actual exports sales in the official trade statistics have remained reasonably robust, past relationships with the CBI survey suggest there should be a collapse in export growth before long. This will put a significant dampener on the economy next year.

Fifth, spending by the Government is, at the moment, under very tight control. Last November Kenneth Clarke published a set of public spending plans which most commentators said was so austere as to be implausible. Before the election, Gordon Brown said he would stick to these plans for the first two years of a Labour Government. So far this year, the new Government does seem to have been able to stick to the spending limits, and it seems likely that there will be little or no growth in real public spending over 1997 or 1998. Like exports, this will also be a strong dampener on economic growth.

Sixth, despite the rise in sterling and the tightness of fiscal policy, there is a severe danger that the buoyant consumer will keep the boom going next year. And there are signs that underlying inflation pressures in the economy are beginning to increase. This is not shown as yet in the behaviour of the retail price inflation rate, excluding mortgages, which continues to rise at the 2-3 per cent underlying rate we have seen ever since 1993. However, the Goldman Sachs leading indicator for inflation has been rising sharply for some time, after dipping significantly when the Bank of England last raised the base rates in 1994/95. Reported inflation data may remain subdued for a while longer, but the underlying trends in the labour market and elsewhere are pointing to a danger of inflation exceeding its 2.5 per cent target rate in the years ahead. This is why higher base rates were, and still may be, needed.

Seventh, this monetary tightening could continue to have an unwelcome effect on the exchange rate. According to the Goldman Sachs equilibrium exchange rate model, the GSDEER, sterling is already about 16 per cent overvalued against the German mark. No one would like to see this overvaluation become any larger, but a rise in inflation would be even less welcome. The UK is following an inflation target, not an exchange rate target, and this means unwelcome fluctuations in sterling will occur. Now is one of those times. Sterling is likely to remain strong until there is clear evidence the economy has slowed down. It is quite likely that sterling will fall during 1998 and it may even be close to its fair value of about 2.50 against the DM by the end of next year, but this fall is unlikely to gather any momentum until GDP growth has dropped. This has not happened yet.

The only significant factor pointing the other way last week was the danger of exacerbating the global turbulence in financial markets by announcing a British interest rate rise. But the UK is tucked away on the fringes of world events, with the economy largely unaffected by the turmoil in Asia and the cycle here untypical of that in the rest of the world. The Bank's move could be seen as an isolated event, with no connotations for the globe.

One last point. The economy has looked quite serene in recent times, but this may be an illusion. In the past, at this stage of the economic cycle, large policy mistakes have typically been made. The failure to tighten monetary policy early enough in the past year means that the same may be happening again.