Relax: rate cuts won't ignite inflation

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The Independent Online
SHOULD WE cheer or boo at cheaper money? The trouble is, anyone who knows anything about finance doesn't trust the Chancellor, and on the record of previous Tory holders of the office, is absolutely right not to do so.

The case for the prosecution runs like this. The evidence of distrust lies in the sour market reaction on Friday to the cut in base rates: sterling off sharply, gilts down, and so on. Whatever the rational case for cheaper money (and it is actually rather a strong one) the collective view of the financial markets on Kenneth Clarke is that he will do his utmost to engineer a pre-election boom. He cannot, as have his predecessors, do so by fiscal policy because that ruse has finally been rumbled. So it will have to be monetary policy. All the changes in the procedure for setting rates, and in particular the publication of minutes of Bank of England and Treasury meetings, count for nothing.

To say all this is not to make an attack just on Mr Clarke personally. The Tories have sought to create a boom before every election in the past; the leopard, so the markets believe, will not change its spots. Given half a chance, they will do so again. In political terms it certainly appears pretty much of a "heads we win, tails you lose" proposition. If they get back, then they have five years to sort out the consequences, raising taxes and putting interest rates up, just as they did last time. And if they don't, well it is someone else's worry.

So much for the prosecution. Here's the defence. Given the clear slowdown in the UK economy during the second half of last year, and the more dramatic slow-down in Germany and France, it would be helpful to ease British rates down if it is safe to do so: much better to encourage a little more demand now, rather than face the danger of growth grinding to a halt. There is very little evidence of renewed inflationary pressure, despite the small rise in the Retail Price Index last week, for most of the red lights that might give an early warning of future inflation - wages settlements, Confederation of British Industry expectations of firms' output prices and purchasing managers' expectations of raw material prices - are not even flashing amber. And finally, the money markets were signalling that further falls in UK rates were expected. This was not a rash act; simply a validation of money market expectations.

Now for the jury: who is right? Well, as always in economics both to some extent are right; and the trick is to judge which thesis is the more appropriate.

Let's start from the conclusion. My own guess is that, though it looks as though the Government is making the same mistake as it always does, and given half a chance would stoke up a mini-boom ahead of the election, this time it won't be allowed to. The global forces of disinflation are too great. And so this cut in rates, plus the further cuts which will take place, will not do too much damage. If it was somewhat unwise to cut rates just at this particular time, at least it was not a real clanger. In the short-term at least I don't think this government could create much inflation, even if it wanted to.

To follow though this argument, the best place to start is with current inflation. The best early warning indicator of this is producer prices, because by the time inflation gets through to the retailers it is too late to do anything about it.

Producer prices come in two halves: the input side, or what companies pay for their raw materials; and the output side, or what they charge for their goods. As the left-hand chart shows, the combination of weak sterling and a rise in commodity prices pushed input prices up to an annual rate of 15 per cent a year ago. Since then they have eased back. But actually they look like coming back even more, for the purchasing managers' survey now reports a balance of managers expecting prices to fall rather than rise. As the graph shows, this index gives a pretty good indication of the future trend in input prices.

Now turn to the output side, shown on the right-hand graph. As you can see the core Producer Price Index (PPI) has been running above 4 per cent for the best part of a year, but the CBI survey showing what companies think will happen to future prices has been easing since the beginning of last year. This too gives some early indications of output prices, so it is reasonable to expect some easing there too. The big picture here is that companies have sought to jack up prices, as they always do. But whenever they try, they find that market conditions force them to pull back. A prolonged period of low inflation, and in the case of houses, deflation, has made us all much more price-conscious.

All this is pretty encouraging. It fits with the Government target of inflation, as measured by the retail price index, at or below 2.5 per cent by the end of the life of this parliament. There is nothing obvious that might upset this: no surge in UK wages, no change of a sudden hike in the oil price. Thus what happens now does not affect retail prices for a year or 18 months. This sober outlook for prices worldwide would suggest that as and when Mr Clarke pushes the Bank of England into another couple of quarter-points off base rates this summer, he will probably get away with it. I suspect, too, that this rate cut will look better tomorrow, when the new fourth quarter Gross Domestic Product figures are published. These will probably show that growth had slowed to a crawl in the last three months of the year.

So it is too early to become alarmed about the Government stoking a pre- election boom and that leading to a subsequent surge in inflation. Nevertheless, do expect a rise in consumption in the coming months, and watch to see if that starts to put pressure on prices. There are a string of special factors which will boost our spending.These include the tax cuts of course, but also the fall in mortgage rates, the pounds 50 average rebate on electricity bills (worth a billion!), the payments by building societies which get quotes on the stock exchange, and the tax-free interest on maturing TESSAs. Given the general job insecurity, people would perhaps be wise to save these windfalls, but Britons are not great savers. The Treasury may well turn out to be right to expect consumers to get the economy growing at 3 per cent this year after the lull in growth last.

But that does not necessarily mean a rise in inflation. Look around the world and that monster is licked. The US is still showing hardly any inflation. In Germany and France it has been beaten down. In Japan prices have been flat or falling for four years.

I think Mr Clarke will push interest rates down as fast as he dares this summer and eventually that policy may lead to signs of strain: weaker sterling, higher wage settlements, companies actually making higher prices stick. The problems will not be nearly as serious as in previous cycles because of the changed international environment ... and if they do show upit will not be before summer 1997 and the headache of a different Chancellor.