The Bank that likes to say it might be wrong
In admitting a recession is possible, the Bank of England is more credible than the Treasury
Thursday 12 November 1998
In a nutshell, it looks as though we will meet the challenge of slower growth by cutting interest rates, and the continental countries will meet it by increasing budget deficits.
In Britain, there was a mass of new information about prospects for the economy and inflation in the Bank of England's latest Inflation Report. The core of the information is unsurprising: a cut in the expected growth rate next year to the Treasury's estimated range, and a shift of emphasis on inflation expectations, which have been notched down.
On growth, it would have been pretty odd if the Bank had been more optimistic than the Treasury, given the fact that the latter is at the top of the forecasting range. It would have been even more odd had the Bank been less optimistic, for it would hardly be likely to admit in public that it thought the Treasury was likely to be wrong, whatever it might think in private.
As for prospects for inflation, you don't need a PhD in macro-economics to appreciate that if growth is going to be lower than previously forecast, inflation is likely to be lower too.
That said, there is one interesting aspect to the Bank's view: it may be right. The particular thing that gives it credibility is the acknowledgement that there might be a recession next year. Given the dreadful record of all economic forecasters, admitting the possibility that you might be wrong would seem to be a necessary preamble to any statement.
In a funny way, by admitting that there might be a recession but then putting the possibility at only 25 per cent, the Bank is more credible than the Treasury, which did not really acknowledge the danger of recession at all. The mass of data this week supports the slowdown thesis, but it does not support anything more dire.
There is clearly still quite a lot of momentum in the domestic economy and that will take a while to come off. The housing market, after a pause in the late summer, seem to be recovering. Consumer borrowing is still solid. I don't think, sifting the data, that a recession could come in the first part of next year as some forecast. I just don't think there is time for that to happen - the problem, if and when it comes, is likely to be later.
Besides, if the inflationary danger has eased, the Bank will be free to cut rates. There is quite a way to go down the path of lower rates, and the sensible assumption on the evidence of the last cut is that the Bank will, if necessary, travel along it. Because the Bank was prepared to do the unpopular thing in pushing rates up, it has earned some leeway when it comes to pushing them back down.
Remember - the Bank's response to inflation is supposed to be symmetrical. Too low inflation is supposed to be as serious an error as too high. The chart on the left, which shows how Japanese policy has over-killed inflation, in contrast to the gradual fall that took place in the US and in Germany, France and Italy, stands as a serious warning.
If it seems a safe assumption that the Bank will cut aggressively if the recession threatens, it also seems a safe assumption that the European Central Bank won't follow similar policies. That is not the cussedness of a new central bank anxious to earn its spurs: it is merely a reflection on the fact that the ECB will have to set a compromise rate. That rate will inevitably be too high for some parts of Europe and too low for others.
Only if recession threatens the whole euro economic zone, or the vast majority of it, can we expect the ECB to start taking risks on interest rates. The thing it will be most frightened of will be the danger that if its rate cuts are reckoned not to be credible by the markets, any decline in short-term rates will be offset by a rise in long-term ones.
That danger is increased if the Maastricht stability pact falls to pieces. There is clearly going to be a shift of policy towards trying to create more jobs - rightly so. While employment in France (right-hand graph) has climbed steadily for 18 months, it is only just heading into positive territory in Germany and Italy.
What we don't really know, though, is how far fiscal policy will be loosened to encourage jobs growth. The more fiscal policy is eased, the more concerned the bond markets will be, particularly for countries like Italy where the debt burden is more than 100 per cent of GDP. The euro zone will inevitably experience convergence of short-term rates, but may see increasing divergence of long-term ones.
This raises two fears. The first is whether widening fiscal deficits will undermine the euro and/or undermine confidence in the solvency of major borrowers in the euro. I don't think that is a danger in the next few months, but you could see a position in a couple of years' time where a sovereign borrower such as Italy could come under serious suspicion.
Unthinkable? It is not a direct parallel, but the present level of the "Japan premium", which Japanese banks pay to borrow funds, would have been unthinkable five years ago.
The second worry is that widening fiscal deficits won't work. If, as happened in Japan, the response to the government borrowing more is for the rest of the country to save more, then a widening fiscal deficit fails to boost demand. This has happened in Japan, and it could happen in continental Europe too.
That would be a grave danger. The tacit assumption behind the "new Keynsians" of continental Europe is that a larger deficit will boost demand. But deficits of 6 to 7 per cent of GDP failed to do so in the UK in 1992 and are failing now in Japan. This week we have caught a glimpse of the way continental Europe will seek to curb the numbers of its jobless. Fingers crossed that it will be more successful than in Japan.
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