Independent/Oxford Forecasts: Room to lower interest rate as UK economy recovers: Inflation is not a real threat to steady growth because of the amount of spare capacity

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OUR latest forecast of UK economic activity is for steady growth. This is the consensus view. Although different commentators hold contrasting opinions over the ability of the economy to ride the tax increases scheduled for April 1994 and subsequently, most expect growth to be in the region of 21 2 to 3 per cent in 1994.

Where we do differ from the consensus is that we do not see growth on this scale posing a serious threat to inflation. A corollary of this view is that we see no obstacle to lower interest rates than are at present discounted in financial markets.

Macro-economists disagree vehemently about the causes of inflation, notably about the role of money in the inflation process. Nevertheless, a view that commands broad agreement is that inflation is likely to emerge where aggregate demand in the economy runs up against supply constraints. From this perspective, inflation is related to the gap between actual output and productive potential. This is not the only possible source of inflationary pressure; but others generally rely on shocks of one kind or another and can be ignored for the time being.

It follows that if, as we believe, the UK economy is currently operating well below its full potential, and given only a moderate rate of recovery, there is little reason to expect inflation to rise. Indeed, a case can be made that as long as the economy is operating below potential there will be downward pressure on inflation.

The absence of inflation risk means only that lower interest rates are possible. The positive case rests on our assessment of policy choices in the run up to the General Election likely to be held in 1996. No doubt the Government wants to go into that election campaign with its tarnished reputation on taxation at least partly restored, and against the backdrop of buoyant economic activity.

Given the underlying deterioration in the public finances, however, it will be difficult to deliver even token tax cuts unless the PSBR is seen to be being brought under control. Rapid recovery would help this cause (although less than is commonly supposed according to the OEF model).

But our central forecast suggests that the strength of recovery in private sector demand will be tempered by a number of factors, including high debt levels, the international trading environment and structural weaknesses in some key sectors. If we are right, the Government will surely be tempted to crank up the pace of recovery using the only policy instrument at its disposal, lower interest rates.

Even if we are wrong and the recovery proves stronger than anticipated in our central forecast, perhaps because the saving ratio falls further, there is still a case for cutting interest rates below consensus levels. In this outcome, however, the argument becomes one of shifting the balance of macro-economic policy: specifically, tightening fiscal policy more than is planned, to make room for tax reductions later on.

The move by the Federal Reserve to nudge US interest rates higher this month has been seen as a turning point in the interest cycle and has depressed sentiment in financial markets around the globe. But there is an alternative interpretation.

For a start, US interest rates are still very low 2 percentage points lower than in the UK), although the US economy is much further along the road to recovery. (The US economy expanded at an annual rate of almost 6 per cent in the fourth quarter of 1993, compared with 2 per cent for the non-oil UK economy.) Secondly, interest rates in the rest of Europe are still heading downwards, as illustrated by the Bundesbank's decision to cut German interest rates on 17 February. And in the Far East, most commentators expect another cut in Japanese interest rates from their present record low of 13 4 per cent.

But if the international background allows scope for lower interest rates, what about the threat of rising inflation at home? In our view this is easily exaggerated. The lesson of the US recovery is that there is no reason why growth should be inflationary while there is spare capacity (fixed capital and labour) to be absorbed. Our own estimate of the UK 'output gap' is in the region of 4 per cent at the end of 1993. This assumes an underlying trend rate of growth of 21 4 per cent per annum for the non-oil economy, which does not seem inordinately ambitious.

Other estimates typically fall in the range of 3 to 6 per cent (for example, the OECD's latest Economic Outlook puts the UK's output gap at 5.7 per cent for the non-oil economy). Even at the lower end of the spectrum the implication is that growth could be 1 per cent above trend (say, 31 4 per cent) for three years in succession before the output gap was closed. And it does not follow that significant reductions in unemployment necessarily imply rising wage growth. Many economists believe there is some rate of unemployment - analogous to capacity output - below which inflation will accelerate. No one knows precisely what this rate (known as the NAIRU) is, although few believe it is as high as the present rate of 10 per cent. The pessimistic story is that the NAIRU will tend to rise during recessions; a phenomenon known as hysteresis. Examples of ways in which hysteresis can occur are where workers become discouraged through prolonged periods of unemployment, and where employers regard the duration that someone has been unemployed as a measure of their prospective productivity (that is, the longer someone has been on the dole, the less employers are willing to pay them).

There are two counter-arguments. First, heightened flexibility of the labour market, to the extent that it has occurred, will work in the opposite direction to reduce the NAIRU. Second, experience suggests that the link between falling unemployment and wage growth is fairly weak. For example, unemployment virtually halved between 1986 and 1990 when the expansion of demand was excessive by any standard, and output rose well above potential. Despite this, and an unfavourably large increase in headline inflation caused by record mortgage rates, the acceleration in earnings growth was comparatively modest. On the wide definition used in the OEF model, wage growth rose from 8.5 per cent in 1986 to 9.9 per cent in 1990, an increase of 1.4 points.

In addition there are developments that bode well for the inflation outlook, ranging from heightened competition in the retail sector to signs that wage bargainers' expectations have moderated. Weak activity in the developed world, bar the US, also helps, by maintaining downward pressure on the prices of internationally traded goods in general and commodity prices in particular.

Fears of rising inflation sit uneasily with the widespread view - apparently shared by the Chancellor of the Exchequer - that tax rises over the next 15 months will slow the pace of economic expansion. It is true that, other things being equal, higher taxes will brake the recovery, but other things will not be unchanged. In particular, we expect consumer spending to be underpinned by lower saving, while continuing low inflation creates room to offset the deflationary impact of tax hikes by lower interest rates.

Indeed, far from the recovery being derailed by higher taxation, our view is that the balance of risks errs towards a somewhat faster expansion of demand, as consumer confidence builds up and unemployment falls. In such circumstances, interest rates might be expected to fall less, and perhaps not at all.

However, our analysis suggests that such an outcome is likely to have only a relatively small impact in terms of reducing the PSBR. This partly reflects the relatively small role of the automatic stabilisers in the OEF model, but it is also illustrative of a little-mentioned consequence of low inflation: namely, reduced growth of tax revenues. In such an outcome, therefore, it would be difficult for the Government to cut taxes ahead of the general election.

It follows that an attractive alternative response would be to tighten fiscal policy further while still bringing interest rates down. Thus, if the recovery gathers pace during the course of 1994, we would expect another austere Budget this November in order to make room for tax cuts in November 1995.

The authors are with Oxford Economic Forecasting

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