Strong growth revives risk of inflation
The economic situation last autumn was never quite as grim as commentators and lobbyists were suggesting
Monday 05 July 1999
Fixed-rate mortgages have been selling like hot cakes. Home-buyers know a good thing when they see one and the opportunity to lock-in borrowing costs at the lowest nominal rates in recent memory - rates which are often comfortably below the current rate of growth in house prices - has been too good to ignore. Indeed, demand for all mortgages has accelerated sharply, and total consumer borrowing has accelerated to its fastest real growth rate since before the 1990 recession.
At the same time, the money markets have been having serious second thoughts about the likely path of interest rates over the next eighteen months, even as the current level of rates has been falling.
A year ago, as it became clear that the economy was beginning to slow sharply, the profile of interest rates incorporated in futures prices suggested that rates would fall, not just in 1999 but also in 2000. Since then, official interest rates have fallen by a third, and the expected path of interest rates has turned upside down: the market now expects rates to rebound sharply in 2000 (see graph). Investors taking a direct view on the slope of this curve would have profited from a movement of two full percentage points.
There have been good reasons for advocating such an investment approach. Month-to-month decisions of the Bank of England's Monetary Policy Committee are difficult to predict with any great confidence, particularly when they are influenced by the exchange rate, as in recent months. Even now, a further rate cut is possible (but not probable, in my opinion) at this week's MPC meeting: the near-term outlook for inflation is very good, and the pound remains strong. But if it has been impossible to pretend great confidence in the precise level at which interest rates would bottom out, it has been perhaps a little easier to take a strong view on a likely rebound.
The stage is set for a solid revival in growth. And not just in the UK: prospects across the world are brightening steadily. Faster growth raises the demand for savings, and tugs real long-term interest rates higher, a lesson which has again been painfully re-learned this year by bond investors across the world.
In the UK in particular, it also raises the renewed prospect of inflation risk.
Readers can be forgiven, at this stage, for wondering what on earth is going on. Less than a year ago, business was gloomy, consumers were frightened and the markets were awash with talk of global recession and deflation. How can things have changed so quickly?
Most visibly, the authorities helped avert a bigger downturn. The Bank of England - and at the global level the Federal Reserve - cut interest rates sharply, stabilising expectations and boosting aggregate demand. But the underlying economic situation last autumn was never quite as grim as market commentators and manufacturing lobbyists were suggesting. The global financial markets certainly got themselves into a pickle; but not for the first time, we have been reminded that the markets are perhaps less important, and more fallible, than we like to think they are.
Now, UK consumers and businesses are realising that the underlying economic situation is not so precarious. Consumers in particular are beginning to recognise that on average, they've rarely (if ever) been as financially secure as they are at present. And with the unemployment rate at an 18- year low, and the number of people in work close to an all-time high, they are increasingly happy to borrow, invest and spend more.
The Government, too, will be doing its bit to boost growth over the coming year. Received wisdom argues that the cumulative tax increases announced by the Chancellor will act as a brake on demand. We have been arguing, by contrast, that the planned acceleration in public spending - which is beginning to show up in the monthly data - turns a superficially restrictive fiscal stance into a potently expansionary one.
Even the export sector will become steadily less fragile as the year progresses. The impact of the sharp loss of competitiveness generated by the pound's ascent is beginning to fade, leaving exporters to benefit, albeit with a lower market share, from the coming revival in world trade.
So if growth does rebound strongly, must inflation risk revive with it? The UK economy unsurprisingly enjoys a higher "speed limit" these days: the amount of inflation associated with each unit of GDP growth has fallen, on a trend basis, to levels not seen since the Sixties. However, this does not mean that rapid growth will have no inflationary consequences whatsoever, and the Chancellor has asked the Bank of England to hit an absolute inflation target, not one which is cyclically-adjusted. Above- trend growth has generated significant inflation risk in the very recent past. Inflation is only now dipping below target, several years later than many forecasters predicted, and only after a slowdown induced by the second-largest real appreciation of the currency in 50 years and (to mid-1998) a sharp rise in mortgage rates.
Commentators who argue that inflation risk is dead might ask where RPIX inflation would have gone if this massive monetary tightening - which they failed to predict - had not occurred. As it was, domestic retail price inflation pushed above 5 per cent in 1997.
Inflation risk is visible in several distinct areas. In the labour market, there has been a steady acceleration in unit wage costs since 1996. Some of this acceleration has reflected a temporary and exaggerated slowdown in productivity growth, but the trend contrasts markedly with the experience of both the United States and the EMU bloc.
The corporate sector, too, may contribute to inflation risk. Margins have exhibited both a cyclical and a longer-term tendency to widen, perhaps because companies care more about profitability in the UK than in the EMU bloc, and because the UK has a bigger service sector, and hence more pricing power.
Gordon Brown's more pro-active competition policy suggests that the Government is beginning to focus on this. But any changes that are inspired by statute will be long in coming. Other mooted sources of perpetual disinflation should be treated with scepticism.
Is it really the case that globalisation is proceeding more rapidly, and at a more intense level, than ever before?
What about the post-war reductions in manufacturing tariffs, and the restoration of currency convertibility - surely these developments had a more profound effect on the competitive environment than the changes we're seeing today? And will the Internet really have a bigger impact than the development of the telephone, or the internal combustion engine, or the aeroplane?
The very next move in inflation is still more likely to be down than up. But if the economy gathers momentum, and the Bank of England continues to base its interest rate decisions on the prospects for inflation in two years' time, then those fixed-rate mortgages could be a pretty smart move.
Ever get the impression you've been here before?
Kevin Gardiner is Senior Economist at Morgan Stanley Dean Witter.
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