One small cut that raises a great debate
Sunday 10 March 1996
The case for the prosecution runs like this. This is the point in the economic cycle at which we always make the same mistake. We assume that, because growth seems to be easing and most of the other economic indicators, in particular inflation and the current account, are favourable, we should continue to push for growth. We cut interest rates and we cut taxes, and invariably this results in an unsustainable boom. Each time this happens there is an excuse why this time things are different: our potential growth rate has risen, foreign investors are confident, the public-sector deficit is coming down, or whatever. And every time it is wrong. And so, just at the time we should be reining back the economy, we give it a further boost. The silly thing is that we keep on making the same mistake when there are lots of different ones that we could make instead.
Now for the case for the defence. We must learn from the past, but this time the lessons are different. There are grand structural changes taking place, both in our own economy and in the world financial environment, which mean that the dangers of giving an excessive boost to the economy are much lower, and the dangers of prolonged recession are much greater.
If you want one single factor that distinguishes this cycle from previous ones, look at house prices: the fact that they remain virtually stagnant despite quite rapid economic growth and steadily falling unemployment shows that the dangers of another runaway boom are much less marked than in the 1970s or late 1980s. Instead, there is a real threat of renewed recession. Witness the fact that our two largest export markets, Germany and France are both either in recession, or close to it.
Which is right? The difficulty is that there is merit in both views but, as so often in economics, it is genuinely difficult to know which is more apposite at the moment. By the time we do know, the damage may be done.
The best starting point is the Bank of England's views on inflation, because if inflation stays low it will validate the fall in rates. If core inflation falls below 2.5 per cent and stays there, 6 per cent base rates are fine. If inflation nudges up towards 4 per cent, 6 per cent rates are too low.
Ever since it started publishing its inflation report, the Bank has tended to be too gloomy, for most times it has had to revise previous expectations of inflation downwards. Last month was no exception, as the chart on the left shows. Back in November the Bank feared that inflation would rise in the first half of this year; in fact it seems to be falling, and now that fall is expected to continue.
In the short term, things look fine. You can get a decent fix on inflation at the retail level for the next six months by looking at producer prices, and you can catch a feel for that from things like the CBI survey of companies' pricing intentions. Everything there seems to be quietening down. Looking further ahead, there are two main concerns, shown in the other graphs: pay and money supply.
By the standards of the last 20 years, pay settlements are remarkably low. They are also perfectly reasonable when compared with inflation. Pay settlements are going up by just less than 4 per cent, prices by just less than 3 per cent: we are not exactly indulging ourselves. But as you can see there has been a steady upward creep in settlements since the beginning of 1994; and as the labour market tightens and skill shortages emerge, it would be natural to expect it to rise further. In a year's time we could back into pay-driven inflation. Not a red light, but an amber one.
The other warning light is money supply. This has been rocketing since the beginning of last year. The old rule of thumb was that broad money should not rise by more than the rate of inflation plus the rate of growth if it were not to "validate" higher inflation. In other words, our 2 per cent growth plus 3 per cent inflation ought to lead to a growth in money supply of 5 per cent. But it is going up by double that. Back in the mid- 1980s rapid growth of money supply was an excellent leading indicator of the late 1980s boom.
The trouble here is that no-one really knows why money supply is shooting up. One intuitive explanation is that both firms and people feel insecure and so are trying to build up cash balances, but that does not really square with higher borrowing, which also has the effect of pushing up money supply.
A technical explanation is that the figures are distorted by changes in the money markets. The most sensible thing to say is that it is too early to panic, but not too early to worry if there are other signs of an inflationary psychology taking root.
My own key indicator of that would be house prices. A modest recovery would be welcome just to give more stability to that market. But if prices start to move up sharply, then the amber signals move to red if authorities do not meet that rise with an increase in interest rates.
If all this is right then the balance of risk at the moment may indeed be that the slowdown across continental Europe is a greater danger than the very small signs of renewed inflation here. Anyway, a quarter percentage point here or there is not important. No one buys a house just because rates have come down a bit, particularly if everyone expected them to go up again soon. Mortgages are usually adjusted every six months, and by the autumn it is possible that rates will be rising again.
Or is it? There is an election coming up. Is it really credible that Mr Clarke would push up rates a few months, maybe a few weeks ahead of it?
And that is surely the nub of the problem. If we had a figure of proven authority in overall charge of monetary policy, like Alan Greenspan of the US Federal Reserve, then there would be no need to fear an over-hasty decline in interest rates because we would know that they would be pushed up if danger signals showed. But we do not. We have a Chancellor who has taken risks by rushing rates down to the limits of what is acceptable and who has so far got away with it, and we have a slightly enfeebled Bank of England that has been overruled and proved wrong.
For the moment, then, the case for the defence seems solid enough. The really alarming signals are coming out of both France and Germany, where retail sales are running down 3 per cent year on year, unemployment is at more than 11 per cent - in Germany - and nearly 12 per cent - in France, and both countries are trying to tighten fiscal policy to meet the Maastricht criteria. We have to rely on British consumers to keep demand rising here because we cannot safely rely on rising exports.
But things could change by the autumn, in which case we could be back to the same sad boom-bust cycle. Governments facing elections tend to take risks, and there is no evidence that Mr Clarke is any different from his predecessors. Indeed, rather the reverse.
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