Prompt action needed from Bank
Monday 14 December 1998
Since he is one of a rare breed of central bankers who find it difficult to frame a boring thought, he seems destined to disappoint himself.
Nor can the Bank of England be accused of courting boredom in recent months. Having still been biased in favour of tightening monetary policy as recently as June, it has now cut base rates by 1.25 per cent in three rapid steps since October. Nevertheless, this is a minimal response, since recent statistics have not painted a pretty picture for the economy.
Gross domestic product (GDP) rose by 0.4 per cent in the third quarter, but much of this growth seems likely to have come in the form of undesired stockbuilding. The Confederation of British Industry's survey suggests companies are building unwanted inventories of finished goods at a faster pace than occurred at any time during the deep recession of 1990/91, and there is a definite risk the employment situation will deteriorate sharply as companies shed these stocks during the winter. This could weaken consumer sentiment still further, making it increasingly difficult for companies to reduce inventories without drastic reductions in production.
It is by no means out of the question that GDP will show an absolute decline in the current quarter, and the Bank may have to work very hard to prevent the situation from worsening in 1999. Business confidence in the UK has been plummeting all year, with the first signs of a really serious deterioration occurring as long ago as April. Initially, this was largely ignored by forecasters, many of whom have traditionally been wary of taking business opinion surveys too seriously. But, as David Walton of Goldman Sachs has been arguing all year, a large and persistent decline in business confidence - especially if it is evidenced in many different sectors - is usually a good leading indicator of subsequent changes in the official economic data.
As the graph shows, the present readings on business confidence taken from the CBI survey are as bad as anything we have seen in previous recessions, even in the deep slumps of 1974/75, 1980/81 and 1990/91. It is a sober fact that if previous links between business confidence and GDP are maintained in 1999, then the economy faces a very bleak immediate outlook. But it would be scaremongering to suggest that these links must inevitably be maintained next year, since there are several key differences between the present situation and the onset of previous recessions.
First, as the Chancellor has argued, the public accounts are in better shape than has commonly been the case in the past, and this offers considerable scope for an easing in fiscal policy to cushion the decline in output during the downturn.
Certainly, there is no reason why the "automatic stabilisers" in the fiscal system should not be allowed to work in full next year. This may increase public borrowing by 1-1.5 per cent of GDP in 1999/2000, but so what? Because public expenditure has been so well controlled for the past five years, the planned increases in health and education spending over the rest of this Parliament can be comfortably afforded, and will offer a useful offset to recessionary forces in 1999. Incidentally, we seem to have heard rather little of late from those who wanted the Chancellor to raise personal taxes significantly as recently as last spring.
Second, there are few signs of the kind of severe financial imbalances in the system which have exacerbated recessions in the past. The private sector - companies and households taken together - are admittedly running a small financial deficit, but it is only a fraction of the 6 per cent of GDP deficit that triggered the recession in the late 1980s. The balance of payments is essentially in equilibrium, and there are few signs of excess in the housing market. Consequently, the problem areas which have forced savage adjustments on the economy in previous downturns are largely absent this time.
Third, and most important, there is no real possibility that inflation will prove to be a thorny issue for policymakers during the early phase of the current downswing. This is a crucial difference between the present situation and the onset of virtually all previous recessions since the Second World War. In fact, most previous recessions have not only been accompanied by inflationary problems, but have actually been caused because policy has had to be tightened to eliminate severe inflationary tendencies.
With these inflationary tendencies generally persisting for a couple of years, policy has typically remained very tight for several quarters into the downswing phase. As a result, there has usually been no countervailing force to offset a decline in business confidence, and there has been nothing to stop worsening confidence from being translated into negative GDP. In fact, an inspection of all the periods of sharply declining business confidence since 1960 indicates that they have never been accompanied in their early stages by an aggressive easing of monetary conditions.
This time it really should be very different. Assuming that real GDP is stagnant for much of next year, the level of output will have dropped well below trend before the end of 1999, and there will be a genuine risk that underlying inflation will drop far short of the Government's 2.5 per cent target in 2000.
Although the Bank of England's report on inflation in November failed to argue that these downside risks to prices were beginning to dominate, the Monetary Policy Committee (MPC) fortunately seems to have taken a very different view when it decided to cut base rates by 0.5 per cent in its December meeting. Actually, the inflation report has not been a very good guide to policy during 1998, which suggests that its role may need to be re-considered.
The key point, though, is that the MPC has not yet succeeded in reducing base rates far enough to put monetary policy into "neutral". Average or mid-cycle real base rates are probably around 3 per cent, so with an inflation target of 2.5 per cent, a neutral level for nominal base rates would be about 5.5 per cent. At a current level of 6.25 per cent, rates are therefore still significantly above a neutral level.
With business conditions dropping at a thoroughly dangerous rate, and the threat of inflation conspicuous only by its absence, there are strong grounds for arguing that the MPC should quickly move base rates at least to neutral, and possibly much further than this.
The "Taylor Rule", which sets an optimal level of base rates according to the degree of inflation and spare capacity in the economy, suggests that rates should drop to below 5 per cent by the end of next year.
"Prompt Corrective Action" is a term that central banks have invented to describe the optimal way to respond to crises in the banking system. This time, the Bank needs to apply the same principle to the whole economy.
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