Fears of hard landing start to recede
There is still scope for the Bank to ease monetary policy further in order to hit the inflation target
Monday 22 March 1999
This time last year, there was still a strong possibility that past patterns might be repeated. Although many cyclical indicators - such as the financial condition of both consumers and companies - were performing much better than in previous cycles, it was an open question whether the considerable tightening in macro-economic policy necessary to control inflation would or would not result in a hard landing.
By the middle of 1998, surveys of business opinion, which had usually proven to be extremely reliable leading indicators for GDP growth, had moved into the extremely depressed territory normally consistent with an outright hard landing. Exports were suffering from a seriously overvalued exchange rate, inventories were rising uncomfortably fast, and consumer confidence was beginning to decline, albeit from extremely high levels.
In the spring of 1999, however, there now seems to be a rising probability that the Treasury's economic forecasts will prove broadly correct, implying that real GDP will fall only moderately below trend during the downswing phase of the economic cycle. Consumer confidence has started to recover, primarily reflecting the monetary policy easing and the continuing healthy performance of the labour market. Equally importantly, there has been some revival in business confidence, though this remains worryingly depressed.
The Government has maintained its forecasts for real GDP growth unchanged at 1-1.5 per cent for 1999, and although this remains above the consensus of independent forecasters, there have lately been some indications that the outside consensus is moving upwards towards the Government's projection. The chance of an unpleasant hard landing, while certainly not remote, therefore seems to have receded in recent months.
Why has this happened? The following factors have clearly been important. First, the mix between fiscal and monetary policy has been quite skilfully handled by both the Treasury and the Bank of England. When the Bank was given operational independence in May 1997, many commentators argued that this would lead to problems by separating the two levers of macro-economic policy into competing camps.
It was further alleged by a majority of observers that the new Chancellor was failing to tighten fiscal policy sufficiently, thereby placing too much of the onus for policy tightening at the door of the Bank.
As recently as 12 months ago - surprising as this may now seem - there were strong pressures on the Chancellor to raise the burden of consumer taxation much more significantly than he actually chose to do. We read much about "one club golfing", with the implication being that the Government should have tightened fiscal policy much more aggressively in the first two years of its term of office.
In point of fact, however, the Chancellor had embarked upon one of the most significant periods of fiscal tightening in the post-war period. Examining evidence in the 1999 Red Book, it is now clear that the cyclically adjusted budget deficit will have tightened by around 3 per cent of GDP in the first two years of the Brown chancellorship. According to the Red Book, this tightening has come roughly evenly from a reduction in public expenditure as a percentage of GDP, and from a rise in tax receipts.
This tightening has had several beneficial effects on the economy - most notably, it has placed the Government's finances in a clearly sustainable medium-term position. This has helped long-term interest rates to remain subdued, even while the Bank of England was tightening monetary policy, and of course it has also reduced the extent of monetary tightening needed to hit the inflation target. Finally, it left both the Bank and the Treasury in a position to ease macro-economic policy sharply if needed to support economic growth.
The second factor which has been crucial in steering the economy away from a hard landing has been the behaviour of the labour market. In particular, the average earnings figures show that wage inflation started to decline around the middle of last year, despite the fact that the unemployment rate was substantially below levels which had previously been consistent with stable inflation. For reasons which we do not yet fully understand, it seems that there may have been a structural improvement in labour market conditions, implying that the equilibrium or sustainable level of unemployment may have been permanently reduced.
If this proves to be the case, the medium-term relationship between the average level of unemployment and average inflation will be much more favourable than it has been in the past. In any case, the early reduction in wage inflation pressure has been crucial in allowing the Bank of England to implement a 200 basis points easing in monetary policy in the last six months, and this in turn has been the most significant factor in reducing the risk of a hard landing.
Where do we go from here? On the Goldman Sachs forecast for real GDP growth, which is slightly more subdued than than that of the Treasury, price inflation would continue to drop on a trend basis over the next 18 months, and on unchanged policy it would probably be more than 1 percentage point below the government's 2.5 per cent inflation target in the first part of next year.
Thus, if policy is not changed, the Governor might have to write a letter to the Chancellor explaining why the inflation target has been missed on the low side in about 12 months' time. This clearly means that macroeconomic policy can be eased further to avoid this potential outcome.
Although the 1999 Budget measures themselves, taken in isolation, introduced a moderate reduction in net taxation, it is misleading to conclude from this that the fiscal stance will ease in 1999-2000. In fact, because of earlier announcements of delayed increases in taxation, and because of surprising reductions in social security expenditure, the Treasury intends to implement a fiscal tightening of around 0-0.5 per cent of GDP in the coming fiscal year. Thus, while the fiscal stance will be less stringent than it has been in the last two years, it will not be supportive of growth in domestic demand in the coming year.
The implication of this argument, therefore, is that there is still scope for the Bank of England to ease monetary policy further in order to hit the inflation target. Goldman Sachs assumes that a further reduction in base rates of 100 basis points will be forthcoming in the next 12 months to keep inflation broadly within 1 percentage point of its central target. Such an easing in monetary policy is of course likely to improve the prospects of achieving a soft landing this year, with GDP growth looking likely to rebound quite strongly during the year 2000.
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