Four reasons why base rates could be cut

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The Independent Online
Isomewhat surprised myself last week by agreeing with the majority of my colleagues on the Treasury Forecasting Panel that some easing in monetary policy might be desirable in the next few months. This change of view came both from recent evidence about inflation pressures in the economy, and also from being persuaded by some of the arguments advanced by Patrick Minford and Tim Congdon at the Panel meetings.

More of that later, but first what future is there for the Panel itself? By the end of this year, the original seven members will be down to three, partly because of the rotation system of enforced retirements, and partly because of career changes. The Chancellor will shortly need to make some new appointments to take the Panel through the election, or else wrap up the institution altogether.

Ever since the press first dubbed us the "wise men", there has been a strong under-current of derision from some quarters. The Guardian established an alternative Panel consisting solely of women. This was presumably to make a point about sexism, which I thought wholly valid, but sadly, like most gimmicks, it sank without trace. Others seemed more affronted by the "wise", and desperate to prove they had not read the Panel's terms of reference, told us to stick to forecasting, and leave policy advice to others.

Meanwhile, the Panel did not get off to a good start, with attention being drawn to a public dogfight between members on the rather obscure topic of the nature of the "LM" curve in Keynesian economics. Not surprisingly, when Ken Clarke arrived, he seemed unconvinced that this sort of thing was a good use of public money. (Actually, the cost is de minimis, other than the considerable use of senior officials' time in meetings and drafting.) Ever since, the Panel's future has seemed somewhat uncertain.

Drafting sessions when reports are being prepared can be as painful as pulling teeth, and this often shows in the finished product. Some of the early reports were little more than six or seven disparate views stitched together. But the 1995 reports have seen an improvement. The two special topics discussed this year - European Monetary Union and the framework of domestic monetary policy - have not produced unanimous reports, but at least they attempted to confront the main areas of disagreement among economists on crucial questions. As far as I am aware, the Panel is the only forum in this country where economists of different persuasions are forced to try to reconcile differing approaches, rather than throwing darts at each other across an unbridged intellectual divide.

This year's reports have produced clear majority recommendations on a series of important issues. Four out of six members recommended against UK membership of EMU in its current form. The same number recommended that the Bank of England should be given autonomy in setting interest rates, within the constraints of the inflation objective set by the Government. Five out of six opposed cuts in income tax in the Budget. And all six said that interest rates should come down if the fiscal stance is left broadly unchanged after the Chancellor's November package. If not full unanimity, then certainly not the undisciplined cacophony of which the Panel is often accused.

This brings us back to monetary policy and inflation. Patrick Minford and, to a lesser extent, Tim Congdon have been arguing throughout the life of the Panel that inflation would remain very subdued for several more years. Though both are seen as "monetarists", and both believe that disinflationary forces are in the ascendant at present, there are crucial differences between them.

The Minford view is that the Thatcherite supply side reforms of the past 15 years have greatly increased the output potential of the economy, and there is chronic underemployment in the labour market. He therefore calls for large cuts in taxes and base rates to take advantage of these supply side gains. The Congdon view is that there is no real evidence of large supply side gains, but that output is some distance below trend. He is opposed to further fiscal easing, but believes base rates could be reduced without jeopardising the Government's inflation target.

In 1994, a succession of favourable surprises on the retail prices front seemed to strengthen the optimists' view of the inflation process, but this year their RPI forecasts have proved too low. The optimists vehemently opposed the 1.5 per cent rise in base rates last year, without which the increase in underlying inflation this year would undoubtedly have been much more pronounced. So it is far from clear that their view has been fully vindicated.

Nevertheless, several factors have tipped the argument on base rates in the optimists' favour, at least for a while. First, growth in the economy has slowed in response to last year's monetary tightening. Although this has only pushed GDP growth fractionally below trend so far, the build- up in stocks has reached worrying proportions, and there is a rising possibility of a pause in activity for a couple of quarters as these stocks are shed.

Second, there has been some evidence of improved underlying performance in the labour market. The Goldman Sachs wage equation suggests average earnings should by now be increasing at an annual rate of about 5 per cent, given the decline in unemployment. In fact, earnings have risen only 3.5 per cent, a difference which might indicate a structural break for the better.

Third, several lead indicators for price inflation have started to improve sharply, even though the recorded inflation rate continues to rise. The graphs show the relationship between producer prices and the purchasing manager's index (PMI), a monthly business survey. The prices component of the PMI dropped from 57.5 in September to 52.5 in October, the lowest reading since November 1993, which would be consistent with an easing in producer input price inflation towards zero in coming months. More importantly, the PMI figures on delivery times suggest producer output price inflation will drop sharply in the early part of next year. This increases the likelihood that retail price inflation will peak by the middle of 1996.

Fourth, the Cabinet seems to have reached agreement last week on public spending plans for 1996/97, which will roughly freeze the real total of spending for another year.Though these plans will be hard to hit in a pre-election period (much harder than the Tory Party seems to imagine), they should ensure that the fiscal stance will tighten next year, even after pounds 3bn of tax cuts. All this makes a small base rate cut much less risky than it seemed a few months ago.

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