Economics: Clarke faces further tests on interest rates

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The Independent Online
KENNETH CLARKE has spent the past week in an unusually bumptious mood, even for him. He has been regaling Treasury officials with his 'bloke in a pub' anecdotes and railing against the glacier-like pace of the department's decision-making.

He has good cause to be cocky. By raising taxes last year, lifting interest rates last week and ruling out tax cuts for November's Budget, he has made three important decisions that are both wise and unpopular. In the long and sorry history of British economic policy- making, few Chancellors of the Exchequer could claim as much.

There have been 10 occasions since 1981 on which interest rates have been raised for the first time after a period in which they had been falling. On all but one of these, the decision was forced upon the authorities by a falling pound, according to the ex post explanations in the Bank of England's Quarterly Bulletin.

Monday's half-point rise may yet prove to have been too small or too late, but the fact that the Chancellor led the markets rather than being dragged helplessly behind them can only bode well. In the light of history, City claims that the move was a panic reaction to last week's inflation figures rather smack of churlishness.

The Treasury issued a shopping list of indicators to explain the rise in base rates, including an unexpectedly rapid revival in overseas markets, higher commodity prices and bullish surveys of manufacturers by the Confederation of British Industry. But the Chancellor's oral explanation was characteristically more straightforward: the economy was probably growing too quickly to keep inflation in the Government's target range.

This explanation also weighed heavily with the Governor of the Bank of England, who went into the meeting with the Chancellor a week ago last Wednesday arguing that rates should be raised. The Chancellor took a couple of days to think things over and decided on Friday that he would go ahead.

The Bank's sense of urgency had been fuelled by evidence that manufacturers were raising prices for the goods they sold on to other manufacturers and by the CSO's revisions to second-quarter gross domestic product figures. The CSO raised its estimate of growth in the year to the second quarter from 3.3 to 3.7 per cent. It also revised data for earlier quarters to show that this growth had taken place from a higher starting point.

Economic growth need not be inflationary, even when it exceeds the 2 to 2.5 per cent the economy has managed to sustain on average in recent years. It is only a problem when the economy's spare capacity is being exhausted or when demand grows so rapidly that the economy runs into short-term bottlenecks before it can be brought into use. Capacity can always be expanded by investment in plant and machinery, but this takes time.

Estimates of the economy's spare capacity differ widely and the Bank has resisted the temptation to give a spurious impression of precision in its Inflation Report. But the CSO's revisions implied unambiguously that there was less spare capacity than the Bank had thought and that it was being used up unexpectedly quickly.

The Treasury remains concerned that even the revised gross domestic product figures may be underestimating the rate at which the economy is expanding. An alternative measure of growth - which looks at spending rather than output of goods and services - suggests the economy may have grown by 4.8 per cent in the year to the second quarter. This is well above both the 3.7 per cent output measure and the 2 to 2.5 per cent long-term trend growth rate.

The pace of recovery amply justified the base rate rise, but we may well be in for some anxious moments as the autumn drags on. There is plenty of evidence that consumer spending has begun to slow, including August's disappointing 0.3 per cent fall in retail sales, weak car sales and downbeat surveys of retailers by the CBI.

This is part of a welcome 'rebalancing' of recovery in which investment and exports are taking more of the strain as tax increases temper high-street spending. A continued slowdown in high-street spending will no doubt be used to cast doubt on the wisdom of Monday's move. But consumer spending still absorbs far too much of the nation's income. We should be more worried if high-street spending continues to accelerate - the danger of rising inflation poses a greater long-term threat to recovery than a stall in demand.

So if Monday's half-point rise in base rates was a response to rapid growth, what will its impact be? It is certainly not enough to bring the recovery shuddering to a halt. Long-term interest rates have already moved higher in the expectation that it was only a matter of time before base rates rose. This suggests that the impact on companies, who rely more on long- term borrowing, should be small.

David Miles, at Merrill Lynch, argues that the impact on consumers could also be fairly minimal for two reasons. First, consumers have plenty of scope to borrow more or save less. Second, the fall in personal sector incomes because of higher mortgage and debt repayments should be largely offset by the higher returns received by savers. Having said this, borrowers are normally more sensitive to interest-rate changes than savers when it comes to deciding how much to spend. So the net effect should still be deflationary.

But controlling inflation by raising interest rates can never be painless. Bank of England research shows that higher rates boost inflation in the short run as companies set prices by adding a mark-up. Inflation only falls when companies are bullied into moderating their prices by wilting demand and the spectacle of other companies going to the wall. The depressing impact of higher rates on national output is at its greatest after 18 months to two years, while the impact on prices is not complete for more than three years.

This implies that there is more to come. Interest rates are still sufficiently low to boost spending, rather than depress it. Over the next year or so, the Chancellor will have to show himself willing to raise rates sufficiently to unwind this effect, although the Bank has no 'natural' rate written in stone to which it wishes to return.

The longer the Chancellor delays, the more dramatic the eventual rise in rates will have to be. The knowledge that Nigel Lawson left it too late - and had to raise base rates from 7.5 per cent in May 1988 to 15 per cent just 18 months later - is etched on his heart.

But Darren Winder, at Warburg Securities, fears the rise in base rates may still prove dramatic. Earlier this year he constructed a statistical relationship in which the level of short-term interest rates was 'explained' by the difference between inflation here and overseas, world interest rates, the current account balance and a risk premium. This equation suggests that base rates could be above 9 per cent by the end of next year.

So Mr Clarke faces two tests if he is serious about what has always been a very ambitious inflation target. First, he will have to show he is prepared to take more tough decisions on interest rates. Second, he will have to resist the temptation to dull the pain with a giveaway pre-election Budget.

And if he succeeds? Labour's fate after Roy Jenkins balanced the Budget just before the 1970 election teaches a sad and salutory lesson - economic virtue does not always receive its just reward.

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