The Bank is right - this cycle could crash

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The Independent Online
When you get Kenneth Clarke, the engineering employers' trade association, the Liberal Democrat economic spokesperson and a fair proportion of City teenage scribblers agreeing that something is wrong, you can be pretty sure it is right. So it was last week with that quarter-point rise in interest rates, courtesy of the Bank of England's monetary committee.

The case for some further rise in UK rates has been clear for some time. The series of rate rises through the summer have not choked the boom, and the latest figures for the third quarter show the economy still growing at an annual rate of 4 per cent. That is not sustainable. Economists can argue whether the long-term trend growth is 2.25 per cent or 2.5 per cent, or maybe even a bit higher still. But it isn't 4 per cent.

When there is plenty of slack in an economy it can grow faster than its long-term trend without the pressure showing through in rising inflation. Up to now, that is what has been happening. But at some stage soon - and no one really knows when because full capacity is not a single simple entity, but a squashy concept - all that slack will have been taken up.

The trick is to allow the economy to rise slowly towards full capacity, maybe encouraging some growth in capacity as a result, rather than letting it burst through and then flop back. Maybe, left to its own devices, economic growth would indeed tail off. But maybe it wouldn't. So it is much better to slow things now rather than allow them to race on and then check them too late. That was the mistake of the late 1980s. It would at least be more interesting were the authorities to make a different mistake this time, instead of the same one over again.

You can see the cyclical position of the economy over the last 20 years in the left-hand graph. While there is not the level of overheating there was at the top of the 1980s boom (or indeed the late 1970s one), we are back to the position of 1986, the time when the policy mistakes which led to the late 1980s boom began to be made.

There was one legitimate reason for expecting the Bank to stay its hand for another month: the turmoil on the financial markets. A rise in rates might be seen as destabilising. Most City analysts bought that view, which is why they were taken by surprise last week. But the mess in the markets is a global phenomenon and has nothing to do with the British economy. In fact, the UK markets have weathered the storm quite well. Doing the wrong thing for the UK economy because some East Asian tigers made policy mistakes really does not make a lot of sense. In any case, a quarter-point is more important as a signal that the UK authorities will continue to lean against inflation than as a powerful direct blow to the economy.

It ought to make homebuyers just a bit more cautious about splashing out, companies just a little more cautious about the quality of their expansion, and all of us a little more aware that economic cycles still exist - even if we must have a marked interest rate cycle now so we don't have such a marked economic cycle later.

This moves to the much more deeply-seated debate behind the fuss about interest rates. Whether the Bank ought or ought not to jack up rates by a quarter-point now or next month is the surface eddy; underneath lies the great swirling current of the economic cycle. Are we really condemned to live under its spell, or has the beast been tamed?

There is a general answer to that question, which is that the amplitude of business cycles has been much lower during the entire postwar period than during the second half of the last century, and lower still than it was between the wars. We have had other problems, in particular the surge of inflation through the 1970s and early 1980s, and levels of unemployment in continental Europe high even by the standards of the last century.

But for a more specific answer, look at the chart on the right. It comes from Tim Congdon, head of Lombard Street Research, whose latest newsletter explains how the cycle operates and argues that we are deluding ourselves if we think that the present benign period of quite rapid growth and quite low inflation will continue.

Professor Congdon's thesis is that there are four phases to the cycle, differentiated by two factors; the level of output relative to trend and the rate of growth relative to trend.

In phase one, growth is above trend but there is plenty of spare capacity (there is an output gap) and inflation falls. In phase two, output continues above trend and the level of output moves above trend too (there is no spare capacity) and inflation rises. In phase three, that rise in inflation triggers higher interest rates and/or higher taxation and cuts in public spending. Output is still above trend, and inflation - for a while - keeps rising too. But growth is falling and eventually output falls below trend. That is phase four, when the combination of slow growth (maybe negative growth) and a return to an output gap mean that inflation is falling again.

Professor Congdon argues that there is a sweet spot and a sour spot in each cycle. The sweet spot occurs at the start of phase two, when inflation is still falling and output is growing above trend. If there is a lag in the fall of inflation from phase one, that sweet spot can last quite a long time. It is, says Congdon, when politicians trumpet "miracles" and economic commentators write about "new eras" and "new paradigms". (Well, some do, I hope not too often in these pages.)

Then there is the sour spot, at the start of phase four. Output has started to fall so unemployment is rising, but because output remains above long- term trend, inflation continues to rise. This worst of all worlds happened in the UK between mid-1974 and mid-1975, mid-1990 and mid-1991.

Comment reflects the mood of these sweet and sour spots. At the sweet spot there is undue optimism; at the sour, undue pessimism. If Congdon is right, such comment is worthless. "At sweet spots commentators should warn of storms ahead and at sour spots they should say that the clouds are dispersing."

Do structural issues not matter at all? Have not, for example, the labour market changes in the US and UK not reduced the long-term trend of inflation? Well, up to a point. Insofar as these changes allow the economy to run at much lower levels of unemployment without there being wage pressures, then there is an improvement in the level of output that can be achieved. But it is a once-and-for-all gain, not a rise in the possible trend of growth that can be achieved. Inflation is still round the corner; it just is a bit further away.

Is Professor Congdon right? Well, because he is brave in his forecasting, we shall see. He believes there will be rising inflation over the next two years with the rise in the underlying RPI to above 4 per cent in 1999; 1999 and 2000 will be the next cyclical sour spot.

My own view, for what it is worth, is that he is two-thirds right. The description of the cycle is clearly recognisable and, yes, an underlying cycle does still exist. There will indeed be a period of below-trend growth, rising unemployment and rising inflation at some stage around the turn of the century, though I feel the sour spot will come after the Millennium, perhaps in 2001 rather than 1999.

Where I disagree is on inflation. Yes, there will be some rise in inflation in developed countries, but the combination of markets and political structures will force policy makers to lean on it hard. So the peak RPI increase will be below 4 per cent, maybe well below. We are seeing those forces now in the UK in things like the action of the Bank last week. If policy makers tighten early they can ease up early too - which they may need to do to fight post-Millennium blues.