Higher interest not a disaster: Michael Artis reports that a small rise in interest rates need not prolong the recession

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The Independent Online
THE message of this, the third BVAR economic forecast to appear in the Independent, is marginally more cheerful than some recent prognoses. Recent evidence of a further decline in output in the second quarter has obliged us to increase the year-on-year fall in 1992 GDP from the 0.1 per cent decline we predicted in May to 0.7 per cent. However, the model still indicates the likelihood of a weak recovery beginning in the second half of the year and strengthening through 1993 and into 1994. The full results are shown in the table.

The BVAR approach differs from conventional forecasts principally in not relying on economic theory and particular models. In a conventional approach, sophisticated computer methods are used to put numbers on relationships that are indicated by economic theory. By contrast, the BVAR approach does not set out restrictive relationships and allows the data to 'speak for themselves'.

In this forecast, the flexibility of the model has allowed us to take on board two important points: the fall in second-quarter GDP announced last week and the decline in second-quarter money stock (M0) figures. The first implies a larger fall in output this year than we forecast last time, while both together suggest a decline in the trajectory of output growth from now on. Nevertheless, a recovery remains in prospect. The forecast trajectory for output picks up speed slowly through 1993, just sufficient to suggest a peak in unemployment of 9.9 per cent of the workforce in the third quarter of that year.

On inflation, for which our quarter-to-quarter forecasts have so far been notably accurate, we find the decline in projected output growth in the current forecast is accompanied by some reduction in the predicted inflation rate. Even so, by the standards set in discussion of the 'zero inflation' goal, inflation looks set to remain stubbornly high. Even with virtually no output growth through the year, our forecast of the inflation rate at the end of 1992 is 3.5 per cent, rising to 3.8 per cent through 1993, as output begins to recover.

All the forecast figures quoted above assume that interest rates stay at around current levels. However, the current lack of confidence in the dollar that is driving up the mark is exposing a lack of credibility in sterling's position in the ERM. This may lead to a rise in interest rates of at least one percentage point. On the other hand, it is not difficult to find reasons why the increase might have to be only temporary - interest rates in Germany will probably fall in response to the recessionary conditions. The loss of confidence in the dollar is likely to evaporate and help sterling.

On these grounds, a temporary one-point rise in interest rates seems to be a scenario worth investigating. The model has been rerun with a six-month increase in interest rates of this size imposed from the beginning of the third quarter. The result is to reduce the output trajectory somewhat: but the temporary nature of the increase tempers the consequences considerably. Over a two-year period from the inception of the interest rate increase, the cumulative reduction in output is only a fraction of 1 per cent of a year's output, and the recovery path remains qualitatively the same as in the main forecast. Of course, a speculative spasm could produce a greater and longer rate rise, and the problems could be exacerbated by an unfavourable French referendum on Maastricht. The consequences for output could then be far more serious, and recovery would remain elusive.

Michael Artis was helped by Wenda Zhang and Robin Bladen-Hovell, all of the University of Manchester's Department of Economics

----------------------------------------------------------------- BVAR'S FORECAST FOR THE UK ECONOMY ----------------------------------------------------------------- GDP Unemploy- Retail price Current A/C growth ment rate inflation of balance of payments % % points % pounds m ----------------------------------------------------------------- Year on year 1990 1.1 5.8 9.5 -16,081 1991 -2.5 7.9 5.8 -5,202 1992 -0.7 9.6 3.9 -10,516 1993 2.1 9.9 3.6 -12,080 Through the year 1989Q4/1990Q4 -0.6 6.1 10.0 -2,640 1990Q4/1991Q4 -1.9 8.8 4.1 -1,416 1991Q4/1992/Q4 0.2 9.9 3.5 -2,749 1992Q4/1993Q4 2.6 9.8 3.8 -3,191 ----------------------------------------------------------------- Year on year: Year's average for unemployment, total for balance of payments Through the year: Fourth quarter level figures for unemployment and balance of payments -----------------------------------------------------------------