Euro will help slay our inflation dragon
The UK might avoid its predicted recession and emerge from the next couple of years in an enviable economic position
Thursday 25 February 1999
One of the side effects of British preparation for the euro will be for us to adopt the European measure of inflation. It won't happen for a year or so, but eventually we will shift. We will shift because politically it will seem rather odd not to shift if indeed the Government is to be spending billions of taxpayers' money preparing for the possibility of membership.
It is one of the few aspects of preparation that is zero cost - or rather has negative cost because changing the way the inflation rate is calculated cuts the cost of the considerable array of index-linked payments that the Government has to make.
The immediate effect of switching to the European method shows up in the graph: we would halve our inflation rate. At the top is the Retail Price Index (RPI), excluding mortgage rates, which as you can see has been close to the target rate of 2.5 per cent since last summer. Below it is the UK inflation rate calculated on the European system of harmonised consumer prices, which is about one percentage point lower, and which has been falling steadily for the past three years. And at the bottom is the euro-zone rate, now down to 0.8 per cent. (The European rate is lower largely because it is a geometric mean rather than an arithmetic one; it also does not include housing costs, which politically might be a bit of a problem here.)
There would be one direct consequence of this: when we adopt the European measure we will have to cut the target for inflation. That is already looking oddly high when compared with the European Central Bank's target of 0 to 2 per cent, or, more accurately, less than 2 per cent, for there is no formal bottom of the range at zero. Presumably we will get the Bank monetary committee to adopt the same target as the ECB.
There would be a second consequence. Even though our inflation rate, on the European measure, is lower than it is on the UK measure, it is still double the level of the euro-zone. So it will have to come down further.
At what rate? To be consistent with the ECB the Bank's RPI target would have to be 1.5 per cent, at least in the view of JP Morgan, which recently drew attention to the differences between the UK and the European measures. As and when we shift to the European measure, the consistent target would be 1 per cent.
What will happen, therefore, is that the Bank of England monetary committee will have to shadow the inflation objectives of the ECB in terms both of the formal targets at which it will be asked to aim, and the outcome it will be expected to reach. It will have freedom to determine monetary policy, but its objective will switch from a UK-set target to a European one. Whether or not we rejoin EMU, a formal necessity for membership of the euro-zone, we will therefore adopt European monetary objectives.
There is nothing wrong with that. Whatever view you take on the wisdom of joining the euro, or indeed the wisdom of the whole euro project, it makes practical sense to keep our inflation outlook reasonably close to that of the rest of the region.
This will have important consequences. We will, until and unless we join the euro-zone, retain our freedom to adjust short-term interest rates to maintain or trim demand, but this will be within a wider objective. The practical result should be that long-term UK interest rates should be more or less identical to those of the euro-zone. Indeed, as Britain has a stronger fiscal position, and a less unfavourable demographic one, than any other large European country, it is perfectly possible that UK long rates will level out below German and French ones - they are already below US rates. Britain is becoming a cheap money country. You could even argue that we are obtaining the economic benefits of the euro zone without the political and economic costs that membership would impose.
This has immediate practical consequences. Conventional wisdom still maintains that the UK will probably have a recession, albeit a mild one, in the first half of this year before growth recovers in the autumn. Core continental Europe, by contrast, is expected to have adequate growth through the year.
The very latest figures from Germany, showing that the economy shrank in the final quarter of last year, have sent a shiver though the markets because there is no practical policy response that Germany can make to this. It cannot do anything about interest rates, because those are controlled by the ECB. And it cannot take any fiscal measures because getting anything through parliament would take too long.
Thanks to the UK mortgage structure, where a cut in rates moves swiftly into people's spending power, it is possible to boost demand here by cutting rates, which of course we still have the freedom to do. So it is perfectly plausible that the UK will scramble though this year without sliding into recession, while a bad first quarter for Germany would mean that it had done just that.
If this line of argument is right, the UK might emerge from the next couple of years in quite an enviable economic position: inflation virtually non-existent, very cheap money, the freedom to jack up domestic demand in the face of continuing continental stagnation. The principal danger would be that the current account would deteriorate to an unsustainable level, and the trade gap has widened during the past few months. But since the current account has tended to produce favourable surprises for several years, largely because of strong invisible earnings, the risks there seem acceptable.
The hardest thing to think through is how we will as a society react to near-zero inflation. How will we feel when the annual pay rise becomes minimal? How will we react to even lower returns on savings in bank and building society accounts? How will we react if taxes go up? We may read economic numbers that say we are getting richer, but maybe if our money wages are stagnant we will not feel richer.
Indeed, maybe we quite like a bit of inflation and will resent it if, on the European measure at least, that dragon is finally slain.
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