Gloom is overdone

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The gloom continues. It is, of course, a gloom confined to the financial markets, for the real economy of both Britain and the United States continues to show steady, low-inflationary growth.

The UK cycle is running some 18 months behind the US, but the pattern of growth is not so different: as the figures come out, some showing decent growth, some giving cause for concern, commentators fuss about the supposed weakness of the recovery. But a year or so later when the figures are revised, the recovery is revealed as being solid all along.

Still, at some stage all cycles turn, and the US interest rate cycle has clearly done so. The American experience is interesting for it should give a taste of how UK markets will react in the future when faced with similar data.

The very fact that the US recovery is so secure and that there are the smallest concerns about inflation has led to the need to tighten policy. The bad temper of US financial markets in recent weeks results from the difficulty they are having in getting to grips with this.

They have had several years during which they could assume that the next movement in interest rates would be down and accordingly simply argue about the pace of the fall. Now the issue is how quickly and by how much rates might rise, and the markets have rather forgotten what it is like to have to worry about that.

This inexperience may explain the difficulty US investors have had this week in interpreting the Federal Reserve's mood. Each statement of its chairman, Alan Greenspan, or other board members is picked over for nuances about future policy.

On Tuesday he said the Fed was likely to raise rates, but left the timing uncertain - a perfectly sensible thing to say. But the markets focused on a further remark about durable goods orders being a factor that might spur inflation. So when yesterday's figures for durable goods showed stronger-than- expected demand, they plunged into further gloom.

Intellectually this is absurd. If you look at what Mr Greenspan has done rather than what he might have said, it is quite clear that Fed policy has been ultra- sensitive to the needs of the US economy. It was aggressively expansionist during the early stages of the recovery, driving down rates and helping rebuild liquidity in both the personal and corporate sectors. It did so without encouraging inflation.

Now it is tightening cautiously and sensitively, moving before inflationary presssures are too evident. If policy during the early stages of the recovery was correctly balanced, is there any reason to assume that it will become unbalanced as the expansion matures?

British markets may be suffering from a similar condition. There has been quite a sharp shift in the consensus on interest rates in the past few days. A week or two ago the general view was that the next movement would continue to be down. That quarter-point cut in base rates puzzled them, for there seemed no real need for a cut at that time. But most still expected the other quarter before the spring was out.

Now people are not so sure. The suggestion by some of the 'wise men', the Treasury economic advisers, that UK monetary policy would have to tighten struck a nerve. Maybe we too should get used to rising rates.

Here the inexperience shows. My own view is that there will probably be another fall in base rates before the cycle turns, and that the first rise will come towards the end of this year. But more important than the timing of the rise will be the extent to which the authorities need to tighten policy.

In other words it does not matter much whether the first rise comes in June, September or February next year. What matters is whether, come early 1996, base rates are at 6, 7 or 8 per cent. A base rate of, say, 6.25 per cent would be acceptable to the gilt market, for that would simply imply a flattening of the yield curve. Base rates back in the 8 per cent region would be disastrous for financial markets, for they would only be consistent with inflation back in the 5 per cent region.

That is what matters: is inflation beaten? If it is, then there is no reason why we should not be facing several years of calm, steady growth. If not, then it is back to stop/go. The question UK financial markets should ask is not whether the recovery is secure. It is whether the progress against inflation is also secure.


The Bank of England is confident in this score, and is probably justified in taking a positive view. But there are a couple of slightly worrying signs.

One is the performance of narrow money, M0, which is rising well above the target range. In the very short term this should not matter: when interest rates are low there is less pressure to hold down transaction balances, and while the consumer remains the main force driving the recovery you would expect companies and individuals to build up such balances. But if narrow money continues to grow at an annual rate of 5-6 per cent, or more, then it should start to ring alarm bells.

The other is pay. By historical standards pay rises are very muted, but public sector pay seems likely to creep up, and there are signs that the latest private sector pay deals are averaging closer to 3 per cent than 2 per cent.

In a way the sudden bout of gloom on the financial markets should come as little surprise. It it is fundamentally healthy that there should be a variety of views in the market, particularly after the euphoria of a month ago. What is unhealthy is the preoccupation with Mr Greenspan. The better barometer to gauge the investment climate ahead in British markets will be UK inflation.