No landing in sight for UK's flying economy

No sooner has it become clear that the economy has been growing solidly than the "hard landing/soft landing" debate has begun. This seems premature, and no doubt reflects partly the understandable sense of shock felt by some commentators who have only just realised that the economy can fly at all. The City is assuming that growth will slow noticeably during the second half of the year and into 1998. But on our reading, growth may not have peaked, and a landing of any sort is not yet in prospect. This is potentially bad news for interest rates - but not necessarily for the stock market.

The strong pound is perhaps the most visible threat to growth. The current episode is now the second-biggest competitive squeeze in the entire post- war period. However, manufacturers are in better financial shape than at any time since the Sixties, and for the time being their order books are holding at above-trend levels, with weak export orders offset by buoyancy in the much more important home market (a source of support conspicuously missing from the increasingly-cited but much more severe 1977-1981 episode). Many models would suggest that with the world economy growing robustly, aggregate exports can withstand the strong pound.

Fiscal policy might yet cool things down. But the Budget tax increases were mostly levied on income which would have been saved, and the package was effectively neutral. The City consensus is loudly and perversely in favour of more fiscal tightening, and Gordon Brown might yet take more decisive action; but a spring Budget could be seven months away - and in my view the Chancellor got it right the first time around. Mr Brown has an opportunity denied to previous Labour Chancellors - to copy his US and German counterparts, and let an independent central bank do his cyclical worrying for him. The Bank of England will not find life easy, but that's their problem.

Mortgage rates have risen noticeably since early May. But rates are rising from low levels, and will take a while to have an effect - not least because one in every two borrowers has an annually reviewed or fixed-rate mortgage.

Most households don't have a mortgage anyway. Indeed, for many, the net effect of the last year's policy mix remains positive: the stronger exchange rate has supported real pay, while the booming service sector has created more jobs in the last three months than the manufacturing sector has done in the last three years - a point, which should reinforce Mr Brown in his determination to remain above the immediate debate.

The main building society demutualisations are behind us. But the effect of the windfalls on spending is unlikely to have been fully recorded yet - not least because a holiday, an R-registration car and a bumper Christmas are three potential candidates for windfall-supported expenditure.

The windfalls may in any case be simply the icing on a very large cake. The average household's disposable income is growing. Consumers are being reassured by falling unemployment, and are backed by a historically high savings ratio and a strong balance sheet - as nervous monetarists will increasingly testify. Confidence was rising when the windfalls were just twinkles in the carpetbaggers' eyes, as was evident from the steady rise in credit usage. And some consumers will have seen their finances transformed: a statistical guinea pig we've been tracking has seen their real post- tax and mortgage spending power double since 1990, to stand two-fifths above the peak of the previous boom in mid-1988. Spending may still be gathering momentum, supertanker style.

If growth does remain strong during the second half of the year, the Bank of England is unlikely to leave interest rates on hold for long. The "new paradigm" school argues that inflation risk these days is negligible, and that strong growth can continue indefinitely without pulling prices up. But the Bank is right to be sceptical.

Inflation risk is visible now. The trade-weighted exchange rate has risen by roughly a quarter, but the impact on retail prices has been smaller than expected, mostly because overseas suppliers and domestic distributors of imports have made the most of the opportunity to widen their profit margins. Anybody seen cheaper German cars, or package holidays? Even manufacturers are reluctant to pass on weak costs, despite intensified competitive pressure: margins on their domestic sales are probably widening as a result, offsetting the impact of the inevitable squeeze on export margins.

Retailers and manufacturers are not exactly shouting this from the rooftops. Indeed, they are much more likely to be heard proclaiming the absence of pricing power. But while they may not be able to raise prices as much as they would like, aggregate price/cost ratios have been stronger than at the same stage of the previous cycle. If the economy remains buoyant and costs stop falling, prices - not margins - could be the buffer.

Some inflation risk is also visible in the labour market. Wages have been remarkably well-behaved by comparison with the previous cycle. However, they look less restrained after adjusting for inflation, and much less so when measured net of taxes and mortgage rates. And there is less slack in the market than at any time in recent memory.

The official inflation target is a tough one - it has been hit in just one month in the last 30. And unless monetary conditions tighten further, it could remain elusive. Official interest rates have risen by a full percentage point since early May. They could rise by as much again and still look unremarkable.

This seems to augur badly for the stock market. But you don't need to believe that inflation is dead and that interest rates have stopped rising to make sense of the market's recent rise. Solid growth in domestic turnover, together with fatter margins, could push corporate profitability up further. Almost unnoticed, the share of profits in GDP is approaching its highest levels for a generation. And as the chart shows, it is the intervening quarter-century which looks anomalous. Not so much a "new paradigm" as a forgotten one.

Kevin Gardiner is a senior economist at Morgan Stanley Dean Witter: the views expressed are his own.

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