Growth will relax without a rate rise
Sunday 02 August 1998
More of that in a moment. But way more interesting than the "will they, won't they?" debate is the "what on earth is happening to our economy?" debate. The monetary deliberations are part of that, but only part. Of course it matters when rates go up, down or sideways; but what really matters is whether there has been a step change in economic performance in recent years. That is what will determine our living standards in the early years of the next century.
The monetary debate fits into this bigger one like this. If there has been little or no change in the underlying performance of the economy, we are at or above full capacity now. The debate about interest rates then becomes a very simple one: whether or not growth tails off of its own accord, in which case the Bank of England's monetary committee does not need to do much, except be ready to cut rates if growth falls too fast; or whether or not it races on upwards, in which case rates will have to rise.
On the other hand, if there has been a step change in economic performance then the judgement is much more complicated. If there is more capacity in the economy, and hence more slack, then it can grow for longer without generating inflationary pressures. So there is less cause for current concern and accordingly more latitude for the policy-makers to consider the medium-term external threats to growth such as the East Asian economic troubles.
The narrow version of the interest rate debate is really a pretty simple one. The members of the monetary committee are required to keep inflation at an underlying rate of around 2.5 per cent. So the issue is simply whether they are doing the right thing to keep inflation on line for that.
Trouble is, the lags between a change in interest rates and the impact on the economy are long and uncertain - anything up to 18 months. So current inflationary pressures, such as they are, are probably the result of overly loose policies in the final months of the Tory government. Since then, the gradual tightening of policy has led to a presumption of ever- higher rates and this, coupled with the strong economic performance, has pushed up sterling.
The graph on the left takes a 40-year look at sterling's real exchange rate - ie the actual rate adjusted for consumer prices. The latest data, for the first quarter of this year, suggests that the pound is about 12 per cent overvalued. The only comparable degree of overvaluation was in the early Eighties. A high pound makes life awkward for exporters, as is happening at the moment, but it also has the effect of squeezing inflation out of the system.
The pound has risen by much more than the Bank of England expected. In the middle graph you can see what sterling has been doing and what successive forecasts of the Bank have suggested that it might do. Seldom have a series of forecasts been so consistently and magnificently wrong.
The Bank was, however, in good company, for most other forecasters also failed to spot the durability of the rise of sterling. Some econometric work by Lehman Brothers on the importance of sterling to UK monetary policy suggests that the unexpected strength warrants the Bank taking a more relaxed attitude to interest rates.
However, in its view this does not support the notion that interest rates are too high. It reckons that the actual output of the economy is higher than the present figures suggest, and if you allow for that then interest rates are about the right level. Looking ahead, however, Lehman Brothers suggests that interest rates can be cut aggressively next year and beyond - something that the markets have not yet taken on board.
I shall spare you the econometrics behind all this but instead thought it might be worth checking on the latest monetary data to see if it confirmed the Lehman view. In the right-hand graph you can see what has been happening to broad money growth, M4. By rights, this ought more or less to equal inflation plus the growth in the economy - or at most be a percentage point or two higher. So if inflation is 2.5 per cent and growth 2.5 per cent then M4 ought to be going up by not much more than 5 per cent. If growth is faster then it is accommodating more growth and/or more inflation; if slower then it is squeezing growth and/or inflation.
As you can see, there clearly was a seriously loose monetary stance 18 months ago, when the increase in M4 was running at an annualised 16 per cent. If you want to know why there was a house price surge last year, look at that line. The money had to go somewhere. Now growth is down to 8.5 per cent. Maybe that is still a bit high, but if you look at M4 lending (a slightly different version of the same series) growth is running at 6.7 per cent, which is pretty acceptable. Add in the squeeze from the rise in sterling and I don't think there is much of a case for still higher rates now. The mistake was last year.
The main bit of evidence supporting the hawks has been rising earnings. These have certainly been shooting up, but arguably are a lagging indicator, reflecting past strong demand for labour. That is the view of DeAnne Julius, the lone voice on the monetary committee voting for a cut in rates. If you listen to what industrialists are saying and doing, demand for labour ought to be easing pretty soon.
What then of the bigger issues - whether there has been this step change in economic performance, and whether the economy's capacity is greater than previously thought?
There is a real difficulty here. Data on services is much worse than data on goods, which is a pity because services are much larger. If it is hard to measure the quantity of output, it becomes impossible to measure capacity or productivity.
When the figures are unreliable, you are pushed towards making intuitive judgements and then hoping that eventually these will be supported by the figures. Intuitively, capacity in service industries ought to be more flexible, provided there are enough people. As for output of services, the tendency seems to be for upward revisions generally to take place, but even these may not capture output fully. What I suppose does capture output is labour demand, because there are practical limits to increasing productivity in service businesses. So they do not employ more staff if they are not producing more output. Current strong demand for labour in services suggests that output has been continuing to rise steadily, at least until the last few weeks.
The truth is that we simply will not know whether there has been a step change in economic performance until long after the event. In another five years we will understand much more about what has been happening to the underlying performance of the economy during this upswing, but for the time being we have to guess.
My guess? I am distrustful of the whole idea of a step change. I don't think that is the way the world works and I remember previous occasions when the same argument has been trotted out. But I think that the improvement in the service industries has been just as significant as that in manufacturing and that this has not yet been reflected in the figures. Does that also mean the economy has more slack than is popularly supposed? I don't think it is possible to know, but clearly the strains are much less marked than the strains at the top of the last boom. Either way a pause in growth right now is welcome - which is a good thing, because that is what we are going to get.
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