Interest rates and angels on pinheads and cuts in rates
Thursday 07 September 1995
The monthly monetary meetings are the focus of economic policy, but the truth is that the Chancellor's decision will not make much difference to the economy.
The economic chattering classes have fallen into a bad old habit that was temporarily shed during the 1980s and put on hold during our membership of the exchange rate mechanism. The mistake is to imagine that the economy can be fine-tuned. Policy decisions will influence the future path of the recovery, of course, and it is fairly clear in which direction rates will go. But there is no telling when, or by how much.
For a start, we have no idea where the recovery stands. Revisions to most statistics are large. The slowdown to 0.5 per cent GDP growth in the second quarter from 0.7 per cent in the first, which has so profoundly changed sentiment about base rates, will be revised. What is more, the composition of growth will be revised, too.
The alarmingly big increase in stocks could prove a chimera. Stocks are one of the hardest components of GDP to measure.
Secondly, the outlook for inflation depends far more on structural change in the economy and the external environment than on base rates. One reason retail price inflation has been subdued is the increased competition between retailers since the onset of the recession. The extra competition will not go away, but falling profit margins will eventually end, removing the buffer that has cushioned consumers against price rises in recent years.
Nothing the Chancellor and the Bank can do will alter these developments. The other important external influence on inflation is commodity prices, which affect factory-gate inflation but have nothing to do with base rates.
How do changes in officially set interest rates affect the economy, anyway? The channels are hazy. The cost of borrowing in Britain certainly does not affect the big companies that dominate the economy. They borrow at world levels of interest rates on the international capital markets.
Lower base rates could help small businesses a bit, but banks' margins on these loans have scope to fall independently, too. The banks are falling over themselves to lend to promising new businesses, even as they refuse loans or charge extremely high rates to riskier ventures.
They do affect households, but home owners have already been granted a reduction in mortgage rates. Building societies and banks, gritting their teeth in the face of a declining business with too many lenders, have decided to accept a tiny squeeze on their margins on mortgage lending.
That leaves the intangible channel of confidence and the impact of interest rate changes on the cost of servicing the existing debt burden. Here again, companies as a whole are insulated from interest-rate effects. The corporate sector is in a healthy financial surplus equivalent to more than 2 per cent of GDP. But individuals, especially property owners, are still heavily in debt.
As Professor Tim Congdon points out in his latest monthly economic review for Gerrard & National, the strain on the personal sector balance sheet is spotlighted by the increase in personal bankruptcies since base rates began to rise a year ago. The number of company liquidations continues to fall.
For the sake of the feel-good factor, if nothing else, it is important for base rates to stay low until the debt overhang is whittled away. But there is a good chance that lower interest rates will not be needed to keep overall economic growth healthy. For there will be some tax cuts in this year's Budget. With last April's tax rises out of the way, after- tax incomes are rising faster than inflation. And during the next 18 months consumer pockets will be enriched to the tune of at least pounds 10bn from building society mergers.
The final irrelevance of the debate about a change in base rates is that Britain's room for independent manoeuvre is limited. The chart shows that moves in UK rates usually simply lag changes in the US, and rarely lie below American or German rates for long. The price for keeping base rates lower than normal relative to others this year has been the fall in sterling, whose value is still nearly 5 per cent lower than it was on 1 January. There is a limit to the amount of devaluation that can be accepted, because of its inflationary consequences.
The overwhelming conclusion is that Ken and Eddie should sit back and enjoy their tepid cup of Treasury coffee this morning and not fuss about fine-tuning interest rates. For all the intellectual energy spent on analysing the monthly monetary meetings, the best the Chancellor and Governor can do is avoid making silly mistakes. It should bias them towards masterly inaction.
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