Riding the mini-cycles
Monday 07 June 1993
The idea that we might have embarked on an era of mini-cycles is supported by recent experience in the United States. The recession there ended early in 1991, since when there has been a continuous recovery. But while the upswing has been continuous, it has certainly not been steady. The graph shows the recent behaviour of the purchasing managers' index, the best of the business surveys in the US. The crucial level in this survey is 50, with readings above this figure indicating an expanding manufacturing sector and those below a contracting one.
On three occasions since the American upswing started there have been serious fears that it was running into the sand. Two of these episodes ended happily, with the economy embarking on a renewed burst of strong growth just when the markets were beginning to talk about slump. The third started just after last November's election, and is only now showing a few signs (such as last Friday's strong employment data) of ending.
A similar pattern has developed in the UK. Although the purchasing managers' survey has been collected here for only a couple of years, the graph shows that signs of recovery in the autumn of 1991 and in the spring of 1992 quickly faded, and there are fears that the same might be happening again. The purchasing managers' index fell slightly in May, and there were also declines in the Halifax house price index, and in the rate of growth of M0 (by far the best monetary indicator of activity in the economy). Despite strong car sales in May, the upsurge in consumer demand in the early part of 1993 seems to have faded since the announcement of tax increases in the Budget.
This stop-start pattern has been observed in the early stages of past recoveries, but this time it has been more pronounced. Why, then, is it happening? There seems to be a tug- of-war under way, in the US and in Britain, between two opposing influences on consumer behaviour and these are essentially taking it in turns to gain the upper hand.
A rum affair
The first influence, which is still undermining consumer sentiment, is the continuing very high ratio of debt to income, which - despite all efforts - has not been reduced one jot since 1989. This has largely eliminated the willingness of consumers to borrow from the banks, which are in any case reluctant to lend except on the most gilt-edged of security. (In fact, this applies literally, since the banks are increasingly holding gilts rather than making loans to the private sector).
A consumer recovery without additional borrowing is a very rum affair. It depends to a considerable extent on the willingness of people to dip into their savings to finance purchases of consumer durables. This is inherently liable to setback.
Luckily, though, there is an offsetting force at work. While the ratio of outstanding debt to income has remained at about twice the level of any previous recovery, it has become far easier to service this debt as base rates have come down. The 'hole' taken out of personal income by mortgage payments has therefore decreased dramatically, leaving room for consumers to finance other purchases. From time to time, this extra money has forced its way out of people's pockets, and they have rather sheepishly trooped off to the shops to spend.
Confidence has been gradually repaired, but not yet enough to make this spending a continuous process. Consumers still need to be persuaded they are getting a bargain. Therefore spending has come in sudden bursts during sales or special promotions by the retailers. But as soon as businesses try to push prices back to 'normal' the flow of spending completely dries up. This cat-and-mouse game between consumers and retailers results in mini-cycles that are extremely difficult to forecast or control.
Furthermore, the mini-cycles are increased in amplitude by the fact that retailers and manufacturers are trying to keep stocks as low as possible. This means that a sudden burst of demand flows quickly through to increased production, with no buffer from inventories. The mini-upswing therefore gathers momentum. But just as producers are beginning to feel confident enough to hold stocks, demand dries up and a mini-downswing starts.
If this is an accurate analysis of what is going on in the economy, there are some obvious consequences. First, it will be almost impossible to produce any serious upward pressure on inflation, since demand will dry up as soon as prices begin to rise. Second, it will be extremely difficult to set monetary policy with any long-term objectives in view. Instead, there will from time to time be intense political pressure to reduce base rates - from whatever level they have by then reached - each time a mini-downswing is in progress. This will rapidly be followed by fears that base rates have been cut too much.
Probably the right thing for the new Chancellor to do in these circumstances is to try his utmost to ignore relatively minor fluctuations in growth as they occur, and to set monetary policy according to his best guess of the needs of the economy in the longer run - rather as the chairman of the Federal Reserve has done so successfully in the US in the past year or two. Whether this will prove politically feasible, of course, depends on the length and extent of the mini-downswings - and on the nerve of Kenneth Clarke.
But this raises the most difficult question of all - what actually is the right level of base rates for the long- term needs of the economy? In America, by common consent, this has proved to be around the 3 per cent mark, which the Fed has targeted for some time. But in Britain there is no such consensus.
A few economists continue to argue for base rates around 4 per cent - and I would tend to agree with them, though only in the context of a significant further tightening in budgetary policy. Others, some of them in the Treasury, see 6 per cent base rates as dangerously low, and probably incompatible with the inflation target of 1-4 per cent. These are issues on which Mr Clarke will need to ponder long and hard.
And there is one more complication, currently only minor though growing quite fast. More than half of all the new mortgages now being taken out in the UK are characterised by fixed interest rates, often of more than three years in duration. Within a couple of years, a large chunk of the house-owning population will in effect have declared themselves independent of short- term fluctuations in base rates, and will instead be influenced by longer- term changes in bond yields.
This will 'Europeanise' the British economy more efficiently than membership of the exchange rate mechanism ever did. And as base rates become less potent, it will leave tax changes as the main way of managing fluctuations in economic activity.
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