Surprised? Look at the money supply
Sunday 07 June 1998
There most of the pundits were, confident in their opinion that there would now be no need for a further rise in rates. The economy was clearly slowing, they asserted, with services now catching the bug that had hit manufacturing. If you allowed for the effect of bonuses maybe the rise in earnings was not too bad, etc.
The rather smaller band of us who believed that it would have been wiser to have increased rates much earlier reckoned we had lost the argument. We might have been right in theory, for the demand side of the economy clearly did need reining back, but in practice the political clout of the production side (and in particular the manufacturing bit) was going to win. The debate might be balanced in the Bank of England's monetary committee, but in the world outside the doves were on top.
Now the debate looks different. The facts have not changed in any substantive way since last autumn: the domestic economy is booming now as it was then, while exporters remain under great pressure - as they were then - from the rise of sterling. But the fact that the monetary committee has finally come round to the view that the inflationary pressures need to be leant on more firmly changes the tone of the argument. Instead of mounting worries about overheating, there was last week a flurry of concern about recession.
Ironically, the fact that the Bank's committee had at last moved - and at an unexpected moment - has led to fears that it might move rates upwards again some time later in the year on the grounds that the committee has become a bit of a loose cannon.
Well, expensive City analysts hate being wrong-footed, so they have to say the Bank has acted irrationally. The exporters' representatives have to say it is terrible because that is what they are paid to do. And the Government has to support the Bank committee because it set up the structure in the first place.
For the rest of us, though, it might seem odd that a quarter of a percentage point on short-term interest rates should cause such a fuss. What then should the sensible non-expert think about it all?
When experts fuss over what seems a tiny decision, I always find it helpful to take the long look backwards. So I am grateful to Professor Tim Congdon of Lombard Street Research for the charts shown here. As we are talking about interest rates the key thing to look at is the growth of money supply: the left-hand graph shows that back to 1950. Since then, the real growth of money supply (allowing for inflation) has been a good guide to trends in the growth of domestic demand, the main component of real GDP.
The fit is not perfect, for in the early 1950s the economy managed to grow while money supply shank. But through the late 1980s - the period most uncomfortably analogous with the present - you can see the way in which real monetary growth of more than 10 per cent a year sustained the boom until both money supply and real growth suddenly headed south.
Looking at the most recent data, you can see how real money supply is again running at about 8 per cent a year (nominal money supply is growing at more than 10 per cent). If the real economy is growing at 2.5 per cent a year, real money supply ought to be growing at 5 per cent or less; it can grow a bit faster than the economy without necessarily leading to inflationary pressures, but not much.
What is pushing money supply up so fast? The short answer is - we are. We are borrowing too much. Look at the right-hand chart. That shows mortgage commitments - loans agreed but not yet taken out - in constant 1987 prices, since 1985. As you can see we are not yet at the 1988 peak, but we are pushing towards late 1980s levels.
There is a nasty little spike on the extreme right of the graph. As Professor Congdon points out, the interest-rate rises of last year have failed to check this growth. There are other components driving up credit demand, but almost half of the UK monetary system's lending assets are residential mortgages, so the growth of mortgages is the most important single force here.
This excessive monetary growth ought eventually to lead to a rise in inflation and a devaluation of sterling, but these things take a while to show through. For the time being these pressures are being offset by a strong inflow of capital from abroad, a lot of it coming in to make acquisitions and the rest chasing our interest rates. That underpinning could hold sterling up close to its present levels for quite a long time.
So what is going to happen?
It would, I believe, have been wiser to push up interest rates earlier, for in this game it is better to be ahead of market expectations than behind them. Had the Bank's committee continued to nudge up rates last autumn, we might well by now have taken the tip off the boom and convinced the markets that the next move would be down. We might have avoided that last little spike in sterling, too.
But we didn't. What I think will happen next will be six to nine months of mixed messages. As far as the real economy is concerned there is going to be a lot of conflicting data, with some parts of the economy moving back to something like recession and other parts bounding on. There will be a fair amount of labour unrest, as we can see already, for the strong demand for labour will take several months to fade away. I don't think the smattering of strikes is a reaction to the change of government, though it may be; it is more likely a response to strong demand for labour.
By the late autumn it will be clear that there has been a pause in growth. It is odds-on that we will get a quarter of negative growth within the next 18 months, and I would guess that by mid-1999 the unemployment rate will be nudging upwards a little. In fact the turn may come this year.
Thereafter? It simply is not possible to call the economy beyond about the middle of next year. There is no reason to suppose that the imbalances now evident are so serious that they will need more than a few months of pause to correct them. A year of below-trend growth and all should be fine. But it would be absurd to claim any confidence. All the experience of previous recessions is that they take everyone by surprise. We know enough to say that a "growth pause" - good phrase, that - would be the ideal way of taking the steam out of the economy, but we don't know enough to be confident that we have engineered one.
If the "growth pause" thesis turns out right, then expect this rise in interests rates to be the last. Expect, too, the first falls in rates to come towards the end of this year - let's say November. Sterling will slither back a bit, but not as much as the bears expect, because the underlying competitive advantages built up over two decades will not disappear overnight. (Did you see that the World Economic Forum last week ranked the UK in fourth position in the world, up from 15th back in 1996.)
As for financial markets in general, what happens here will be of less consequence than what happens in the world economy in general. The continental European recovery is at last coming through; when the US economy comes off its present growth curve, as eventually it must, the core EU countries will be the principal source of demand in the world. It is unrealistic to expect the East Asian time zone to provide much growth for another 18 months, maybe longer. The markets will therefore have to adjust to a period of slower global growth, with all the consequences that will follow.
There is nothing we can do here about that. We have merely to manage the 5 per cent of the world economy that takes place on this island as best we can. The monetary management of the last couple of years has been sub-optimal, but if that little upwards nudge of rates last week clips the top off the boom then the Bank will have started to re-establish its reputation for competence.
Besides, central banks need to retain their capacity to surprise. If they were wholly predictable the markets would always gain the upper hand.
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