Economics: Why Labour needs us to be frightened
Sunday 30 March 1997
This year the habitual Easter boomlet is given a special twist by politics, for the election has almost certainly delayed the next rise in interest rates. There has been mounting evidence in recent weeks that the economy is growing rapidly, with average earnings now rising above 4 per cent, and consumer demand increasing at about the same rate. There is also the clearest evidence of the first stages of a housing boom, with prices, according to Nationwide, up nearly 10 per cent year-on-year.
Given this, it would be very surprising if an incoming Labour government did not take the advice of the Bank of England and stick up rates. There will be a monetary meeting on 7 May, a week after the election, so expect a rise then - or maybe if they feel the need to get their feet under the table before accepting the Bank's advice, after the next meeting in June. The first rise could easily be half a percentage point, particularly if the new chancellor wanted to set more of a Calvinist tone.
And after that? There is a big question here: how will people behave under Labour? Will we be more cautious, fearful of higher taxation, higher interest rates, and even greater job insecurity? Or will we assume that there is no need to cut back on spending or borrowing and expect that job security will improve rather than deteriorate?
The way we, as consumers, respond in the next few months is of enormous practical importance, for it will determine how hard the new government has to lean against the boom. If we go on spending, it will have to choke the boom off fast; if on the other hand we rein back then it has more time to think while formulating its policies.
The most important single thing here will be the housing market. If prices go on rising sharply, some of that rise is bound to leak into general consumer spending. That is partly because of the wealth effect: if people feel richer because of a rise in the value of their house, they are inclined to spend part of that wealth, even though their incomes have not changed. It is partly because of the practical business of moving: when people move house they spend money on new carpets and new electrical equipment to put into it.
Through the early stages of the present expansion, none of the traditional signs of overheating developed. Growth was steady rather than spectacular. There was no balance of payments crisis. In fact the current account improved and moved from deficit to balance. There was no surge in inflation. Savings rose. Why? Well, we don't really know for sure, but at least part of the answer must lie in the housing market, for the searing memories of the long slump made people cautious.
So what will happen? My crystal ball is no better than anyone else's, but I was intrigued to see the results of a new econometric model for forecasting house prices, developed by Professor David Miles of Imperial College for Merrill Lynch. Anyone who has used such models knows that their results have to be taken with a pinch of salt, for economic variables which have been stable for a long time have a nasty habit of changing suddenly when they are put into econometric models. Nevertheless, the results of this exercise make interesting reading for they suggest that the present rise in house prices has a long way to run.
These results are shown in the graph, both for real house prices and for nominal ones. The report suggests that house prices a year ago were some 25 per cent undervalued compared with their long-term trend. The model almost exactly predicts the speeding-up of prices over the past year and forecasts that the rise in real house prices will peak at an annual rate of nearly 13 per cent in the first quarter of next year. The rise in real house prices then slows, dipping back to zero in 2001, then climbing back to 4 per cent a year by 2007, the end of the forecast period. Inflation remains low until 1998 when it starts to pick up - a lagged response to faster income growth and higher house prices. It keeps rising to 2001, when it reaches 7.5 per cent, and stays at that through to 2007.
Now immediately you can see a problem. Inflation is not going to rise to 7.5 per cent a year. Or rather, if it does, all the mainstream present projections of the financial markets are up the spout. The model predicts this because that is what would have happened had the normal post-war relationships still held good, but we can be pretty sure that the dynamic changes which have taken place in the world economy over the past 15 years will mean those relationships are no longer valid.
Computers do what they are told to do, and this one has not been told about the power of the bond markets, the independence of central banks, or the globalisation of the world economy - all changes which have helped turn the long-term trend of inflation from up to down. Nevertheless, the real house price charts may still be right. Indeed if you feed in lower general inflation rates, the real increase in prices is apparently a bit larger.
In any case, what happens to house prices in the year 2007 will not be a great policy issue this summer and autumn. The worry then will be that the shorter-term projections of the house price boom continuing well into 1998 are right, because if they are then expect the new government to have to lean hard against the rise by jacking rates up hard through the rest of the year and into 1998.
How hard? If you look at the interest rates projected by the futures markets, the three-month interbank rate (a good proxy for base rates) reaches 7 per cent at the end of this year and rises to 7.5 per cent by the middle of next. That just happens to be the present view: it may be right, it may be wrong. Still, the idea that rates will tend to climb right through to the end of next year probably squares with what most professionals in the world of finance expect. It feels sort of right.
But we will be able to judge much better in three or four months' time when we see how people react to a change of government. If the new caution evident through most of the past five years carries on then the rise in house prices will not continue to build strength. People will remain cautious about over-mortgaging themselves, and while they may well want to jump in quickly, they will not trade up in the way they might have 10 years ago. And they certainly won't use any increase in house prices as an excuse to spend more on buying other things. The rise in prices at the moment is still quite localised, with sharp increases in the South- east and not much happening elsewhere. Maybe the rise will not spread outwards as much as it has in previous booms.
Maybe, too, a quick half per cent on interest rates and some tax increases in the first Labour budget (they only said they won't put up income tax rates) will defuse what modest enthusiasm might otherwise exist. We will see.
But it is an interesting paradox, is it not? To get elected, Labour needs people not to be frightened. But to avoid having to do unpopular things once it is elected, like pushing interest rates and taxes up sharply, it needs people to become frightened again. The more frightened, the more cautious, the more we save rather than spend, the easier it will be to control the boom.
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