Is this optimism or complacency?

Click to follow
The Independent Online
One of the City's most pessimistic economists appeared on television last week to comment on the Treasury's extremely rosy new forecast for the economy.

This forecast, he acidly observed, came from the same team that failed to predict the Lawson boom, ruled out the possibility of recession, did not foresee sterling's exit from the European exchange rate mechanism and denied the need for tax increases at the time of the last election.

Now, he continued, they were telling us to expect a self-sustaining recovery in activity with no inflationary pressures or balance of payments problems on the horizon. Why should we believe them this time?

Obviously all forecasts are fallible, but there is no reason based on past evidence to believe that Treasury forecasts are any more fallible than anyone else's.

And, although there is always a suspicion of political interference whenever government forecasts are unveiled, I doubt if Alan Budd, the chief economic adviser to the Government, and the rest of his team would lend their reputations to a document that did not approximate to their genuine view of the most likely out-turn for the economy.

While they have not actually signed the document - it would be a further useful step towards policy transparency if the Treasury forecast were formally published by professional economists rather than by ministers - there is no significant difference between the official Treasury view and that produced by the Panel of Independent Forecasters. And, whatever names may be thrown at the 'wise men', it is difficult to accuse them of being Government lackeys.

But, having said all that, there are certainly reasons for worrying that this year's Treasury forecast may in the end prove fractionally optimistic.

This optimism is based on two key ingredients. The first is that domestic demand will grow at a 'perfect' rate of around 3 per cent per annum, and the second is that the economy still has plenty of spare capacity to meet this demand.

FORCED TO SPECULATE

The danger to the first of these ingredients is no longer that demand will slow down too much as the tax increases bite, but that it will speed up too much unless interest rates are raised. Unfortunately, we cannot tell whether the Treasury forecast has assumed that interest rates will need to go up in order to restrain demand growth to 'only' 3 per cent per annum.

Since they do not reveal their base rate assumptions, it is conceivable that their rosy scenario only comes to pass because they have assumed a sharp rise in base rates. But there is no sign from other aspects of the forecast - in particular the inclusion of a broadly stable path for the exchange rate - that this is the case.

It is a pity that we are forced to speculate about this, since it makes the forecast awfully hard to use as a tool for policy analysis in the outside world. Surely the time has come for less opaqueness in this area. After all, it is perfectly possible to make neutral assumptions about interest rates that would not upset the financial markets, especially if the assumptions were taken from the rates built into the markets themselves. The US administration appears to have no trouble with this, but on this side of the Atlantic we remain unnecessarily coy.

Anyway, assuming there is not much of a base rate rise built into the forecast, the predicted growth in domestic demand may well turn out to be too low. The Treasury seems particularly cautious in its assessment of company spending.

Capital investment is expected to rise by only 4 per cent next year and, very surprisingly, stockbuilding is expected to contribute only 0.2 per cent to the growth of GDP.

In view of the robust financial health of the company sector, this forecast could prove much too low. Surprisingly, the Treasury offers no explanation for the fact that stocks are expected to contribute much less to the 1994-95 upswing than they have done in past recoveries.

A more plausible expectation would be that company expenditure will be a lot stronger than the Treasury expects, boosting the growth of demand to well over 3 per cent per annum.

But, even if this were to occur, there would be little reason for concern if the Treasury proves to be right about the degree of spare capacity in the system and the way in which this affects inflation.

The key excerpt from the Summer Forecast is the following: 'Looking ahead over a run of years, the trend in inflation will depend on the degree of spare capacity in the economy. Typically, inflation tends to fall when there is spare capacity. Most estimates of the output gap still point to a sizeable margin of excess capacity, and hence to considerable further downward pressure on inflation in the medium term.'

Note the simplicity of this model of the inflation process. There is no direct mention of monetary aggregates or the exchange rate, though the Treasury would presumably not deny that both factors can influence inflation indirectly via their impact on the output gap.

Furthermore - and crucially for policy at the present juncture - there is no indication that the rate of change of the output gap, as opposed to its level, can influence inflation.

Taken to its limit, this implies that the rate of growth in the economy, and the pace at which unemployment falls, does not have any effect on inflation as long as the level of output remains below trend. For example, if output is 4 per cent below trend, and if the trend rate of growth is 2 per cent per annum, Britain could enjoy a year in which GDP growth reaches 6 per cent without this leading to any rise in inflation.

If this view is accepted, there is no need to worry about inflation for at least two more years, since there is virtually no chance that output will grow fast enough to restore the economy to trend over this period.

An alternative view, however, is that the economy is subject to a kind of speed limit, whatever the level of spare capacity from which it starts. If it exceeds this speed limit, temporary bottlenecks and shortages of labour can lead to increases in inflation, even though the level of output remains below trend.

CRUCIAL DIFFERENCE

The graph shows the results of simulations on the Goldman Sachs inflation model, which allows both the level of the output gap and its rate of change to influence the inflation process.

On this model there is a crucial difference between 3 and 3.5 per cent output growth for the inflation rate after 1995. This is because, at the faster growth rate, the inflationary consequences of a decline in the output gap eventually begin to outweigh the fact that the level of output remains below trend for most of the simulation.

Since GDP growth could move above 3.5 per cent quite soon, this view argues for a very cautious approach to monetary policy.

The logic behind the Treasury view, on the other hand, is that a burst of rapid output growth of this sort should not cause inflationary problems for quite a while - in which case any tightening in monetary policy in the next year or two need not be very great.

I am sure Mr Clarke would like to believe this optimistic view of the world - and at the moment his economists are egging him on to do so.

(Graph omitted)

Comments