The danger of ignoring the experts
Sunday 28 May 1995
He is certainly a most convivial companion and almost certainly a skilled politician, but not even his closest friends would claim that he had a natural feel for the arcane science of monetary economics.
All the experts at the Bank of England (and almost certainly his own advisers at the Treasury) had urged him that an immediate increase in base rates was necessary. The financial markets thought so too and were signalling that one was about to happen.
But the catastrophe of the local elections intervened and the skilled politician drew on his knowledge of monetary economics and judged that the state of the economy did not justify an interest rates rise just at that time.
So far this judgement looks rather good. What seemed a clear-cut case for an early tightening of policy looks much less certain. The earlier concerns about rising inflationary pressures remain, but during the past week there emerged new evidence of a slow-down in the economy.
Revised GDP figures suggest that it seems to have grown more slowly in the first quarter than had been thought, the pressure on the pound eased, and that important indicator of the buoyancy of the economy, the housing market, has clearly softened. The particular indicator to watch here is not house prices, which shift only slowly, but housing transactions, which give a sensitive and speedy feel for the confidence of home-buyers. And transactions are running 17 per cent down on last year.
But is Mr Clarke really right? On a one-month view he may look clever, but what about a six-month? Could it be that by not going up now, rates will have to rise further at some date in the future?
The markets have a dreadful habit of over-emphasising the most recent statistics, and you have to stand back from that. Looking a touch longer- term, there seem to me to be two powerful reasons to suspect that Mr Clarke's judgement will look pretty good for some time, but alas rather more reasons to suspect that it won't.
In the Clarke corner, so to speak, is the Bank of England's record of over-pessimism in forecasting inflation. The Bank has been running its inflation forecast since February 1993, so we now have more than two years' experience. But as the graphs from May 1993 (the second of the series), and May 1994 show, it has consistently over-estimated the inflationary dangers. The dotted line shows what the Bank thinks will happen; the solid line what actually happened. (The other reports, by the way, all show much the same pattern.)
So what credibility has the final forecast, that for May this year, really got? On past performance, the outturn on inflation will be way below the forecast - the solid line will turn out to be below the dotted one yet again. Natwest Markets, which drew attention to the way the Bank cries "wolf" on inflation in a recent paper, believes that the Bank is establishing a reputation as an inflation pessimist, which will give political chancellors ammunition to reject its advice.
The second reason for supporting the Chancellor is the housing market. There has been a slight slow-down in the growth of the economy, to be sure, but it is still growing at nearly 3 per cent a year, which is higher than its natural rate of growth. It is perfectly natural for it to pause for breath at some stage: recoveries often do. It could slow a lot more before that should be a real concern. But the soft state of the housing market does support the idea that an early further rise in rates is not needed.
Ironically, the rise is not needed because the housing market is already expecting one. Virtually all home-buyers must be aware of the danger of another rise in rates - indeed, given the experience of past cycles, they may be too pessimistic. And since the supply of fixed-rate mortgages has again become restricted, most would-be buyers need to build in some leeway in their repayment schedule for future rises in rates.
This helps put a damper on purchases, which in turn restricts consumption in two ways. The direct effect is to put in danger the purchase of many consumer durables, for people tend to buy new washing machines and dishwashers when they move house. And doubt about the value of a home, or the ability to sell it, has the indirect effect of making people feel less rich, and accordingly less willing to splash out.
If those are the main reasons for believing the Chancellor's judgement will look good, why might it look bad? There are at least five.
First, there is quite a lot of inflation already in the pipeline from the fall in sterling this year. The CBI's monthly trends survey shows that firms still expect to be able to push up prices. It may well be that growth through the middle of this year will ease somewhat, but prices will trend up simply because of cost increases which are already known.
Next, there will have to be some further rise in UK rates at some stage because international interest rates are still rising. US interest rates are almost certainly going to rise again.
True, the current fashionable view in the US is that that may not happen; that growth will quietly ease off without any need for further rises. But people's incomes in the US are still rising strongly, inflation in the past three months has been rising at an annual rate of 4 per cent, and unusually in the US, savings have been rising too. So expect another burst of demand there - and expect a rise in rates to meet it.
Third, add in German rates. The current debate there is whether there is room for one more interest rate fall. There may be. But in another six or nine months the German cycle will turn too. It would be uncomfortable, when that happens, if UK inflation did not seem firmly under control. There is no direct relationship since we are not linked in any way to the German mark, but we would need to have a credible reason for not following suit.
Fourth, look at market expectations for UK rates. You can see what the market expects either by asking for people's forecasts and working out a consensus or by looking at the rates implied by the futures market. The consensus shows rates in May next year a bit under 8 per cent, and the implied rate is 7.7 per cent.
That may not prove right, but it would be very odd if it were to be wrong as to direction. So, assuming rates rise by 0.5 per cent each time, expect two more rises in base rates from the present 6.75 per cent.
Finally there has, I think, been some cost to the Chancellor's action which will only be evident in the months ahead. He has been lucky. But he will also now be less trusted. It would be difficult for him to resist pressure for a rise in rates next time: the fact that markets have come his way suggests that there will not need to be a rise after the June monetary meeting, but on balance I would expect one in July. The danger is that Mr Clarke will come to be regarded as too "political" for the markets. Had he been prepared to see a rise in rates this month, he would have had much more leeway in the future.
It may even be that by seeming reluctant to increase rates now, he has narrowed his ability to cut rates when the cycle turns some time towards the end of next year: it may be more difficult to cut rates in the run- up to the next election. Maybe he is not such a clever politician after all.
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