Is this the start of a cut-and-run poll strategy?
"The Chancellor may be gambling that further information will be forthcoming in the next few weeks, confirming his interpretation that economic activity is slowing down"
Tuesday 09 May 1995
There are only two interpretations for what Kenneth Clarke seems to have done; one is fairly benign, the other less so. The benign interpretation is that the local election results were even worse than expected, and that Mr Clarke was taken aback by the concerted attempt by the right of his party, overnight on Thursday, to make him the scapegoat for the defeat. He may simply have decided that last Friday was not the day to test the Tory party's endurance, never mind the electorate's, with a two-fingered monetary policy salute.
If this is the case, then the increase in base rates will be delayed only for a month, and no real damage to the economy will be done - or so Mr Clarke may have been tempted to conclude. After all, the present monetary arrangements have always allowed for the possibility that the Treasury may not agree with a monetary recommendation from the Bank.
On this occasion, the Chancellor may be gambling that further information will be forthcoming in the next few weeks, confirming his interpretation that economic activity is slowing down, and potentially leading to a change of heart by the Governor. If this happens, Mr Clarke will turn out to be quite a hero, especially in his own party. If it does not, then the Chancellor can reverse his decision next month, and raise base rates before the minutes of last Friday's meeting are published.
Mr Clarke was apparently motivated by a belief that gross domestic product growth in the first quarter will be revised down from the initial estimate of 0.8 per cent. This estimate was certainly an oddity, since it showed all of the growth in the economy coming in the services sector. The Central Statistical Office may have mistakenly allocated too much of the lottery expenditure to GDP, when in fact the GDP effect should be close to zero.
If so, the initial estimate for growth in the services sector may come down. Offsetting this is the fact that the official CSO estimate for manufacturing output is much lower than the level implied in the Confederation of British Industry survey, and in the past such disputes have often been resolved in favour of the CBI. This would suggest that any downward revision to services output may well be counterbalanced by an increase in manufacturing. My impression is that this is what Treasury officials expect to happen.
It would be embarrassing for the Chancellor if the GDP figures were to be revised upwards, but nothing that a robust politician could not live down. Mr Clarke would simply say that the checks and balances in the present monetary system were designed to permit occasional periods for reflection before making important policy adjustments. And he would be justified in thinking that even a fully independent central bank like the Bundesbank accepts the existence of "no-go" zones during which interest rates cannot change for political reasons. A Bundesbank transplanted into Britain would certainly not have raised base rates last Friday, so why should we?
The reason of course is that our monetary authorities do not yet have the credibility to enjoy some of the little luxuries open to the Bundesbank. Every time the Chancellor tampers with the Bank's recommendations for political reasons, he delays that day.
He has now tampered three times in 15 months. In February 1994, he imposed a quarter point cut in base rates against all of the advice from both Treasury and Bank officials. Last September, he undermined the beneficial credibility effects of an "early" cyclical decision to increase rates by needlessly delaying implementation for two days after the monetary meeting - presumably to allow more time for political soundings to be made. And now this.
Mr Clarke seems to treat the new monetary mechanism with less than total reverence. Even if base rates are duly raised in a month's time, the markets will know that politics still intrudes into UK monetary decisions in a very big way, and as a result the average level of long-term rates from now until the election will be higher than it otherwise need have been. That is the cost of Friday's events, even on the most benign interpretation of the Government's motivation.
A less benign interpretation is also possible. Last week may have seen the start of something far more important than a short-term body swerve on base rates. During his press conference on Friday, the Chancellor left the clear impression that he expects little or no further rise in base rates during the rest of this cycle.
Admittedly, this might also be the Bank's best guess of the most likely out-turn, but it would be only a guess. Very few independent forecasts show inflation within the bottom half of the 1-4 per cent target range in two years' time. Until they do, a risk-averse Chancellor should not be talking about a peak for base rates.
As the graph shows, the Goldman Sachs leading indicators for inflation, developed by David Walton and Martin Brookes, imply that inflation pressures are likely to rise for several more quarters, with the 1-4 per cent band itself, never mind the bottom half of that band, being breached next year. A government truly risk-averse on inflation would certainly wish to raise base rates now, just to be on the safe side.
But perhaps Mr Clarke has noted that the longer leading indicator for inflation (with a lead time of 20 months) is already falling. Perhaps he is willing to face down Mr George not just for a few weeks, but for much longer.Perhaps he is prepared to back a hunch that underlying inflation pressures in the economy really are much more subdued than the Bank believes, in which case we might discover in a couple of years - far too late to rescue the Tories - that further base rate rises were never really needed. Perhaps, in short, the Government is now shifting towards a much riskier, even a "cut-and-run" approach to economic management.
A friend in the financial markets has likened the Government's political position to that of the holder of an option contract whose strike price is well out of the money. If they choose to remain on the present stable course, the option will expire worthless - the election will be lost. So they need to take a risk and inject some volatility into the market. Higher volatility will raise the price of the option, since it increases the chance that it will expire in the money.
In simple English, a high-risk strategy may start to look very appealing to a government whose safety-first approach now seems increasingly destined to lose. That may be the real lesson of last Friday's escapades.
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