The fiscal dog decides to bark just as tax rises bite
Monday 20 February 1995
The government backbenches are certainly fertile territory at the moment for panic about the economy. A fortnight ago, when addressing a meeting of Tory MPs with special economic interests, I was struck by how much scepticism existed about the sustainability - even the existence - of the economic recovery.
There was a wistful longing for a burst of inflation in the housing market, and even an acceptance that a rise in general inflation, say to 5 - 7 per cent, would be a price worth paying for an election win. For the first time in quite a while, I began to have doubts whether Eddie George's crusade for low inflation would be allowed to stay the course by the political process.
There is little doubt that if a free vote on monetary policy could be held today among government supporters, there would be a sizeable majority for immediate cuts in base rates, even if this meant that the 1 - 4 per cent target band for inflation would be sharply breached before the election. Fortunately for the Chancellor, and fortunately for the good of the economy, no such vote will be held.
But Parliament will of course have the right to pass judgement on the Chancellor's pre-election budgets, and it seems impossible that these will get through without sizeable tax cuts, undesirable though these may be. The problem for Kenneth Clarke is that most of the weakness in consumer demand at the moment is directly attributable to the two budgets of 1993, which pre-announced a massive programme of fiscal tightening. He is therefore directly "to blame" for the sluggishness in the High Street (sorry, in the out-of-town shopping centre, as it should now be called).
For most of last year, it seemed that the budgetary tightening was failing to affect demand, and there was much talk in the Treasury about the fiscal dog "failing to bark". But in the past few months, it has been not only barking, but biting as well. Furthermore, in the eyes of some of his supporters, Mr Clarke has compounded his felony by increasing interest rates at precisely the moment that the tax increases were having their maximum impact on the economy.
`Feel-bad factor' among home-owners
Politicians in search of an explanation for continuation of a "feel-bad" factor several years into a strong economic recovery need search no further than the first graph, which shows the combined impact of mortgage rate changes and tax changes on disposable income of a home-owning family since sterling left the ERM in 1992. (The calculations, made by Martin Brookes of Goldman Sachs, exclude the impact of changes in interest income for households with monetary assets; the figures should therefore be taken to be representative of families with a mortgage, but with no sizeable savings.)
In the period after the ERM debacle, the immediate cuts in base rates undertaken by Norman Lamont added about 1.7 per cent to the disposable income of the family type we are examining, and most of this boost remained in place throughout 1993, since the tax increases announced that year did not take immediate effect. During this period, retail sales volume grew at an annualised rate of around 4 per cent. Even then, the weakness in the housing market prevented the emergence of a "feel-good" factor, but most Tories admitted they could detect the emergence of a "feel-better" factor.
However, in April 1994, the monetary stimulus was almost exactly offset by the first round of the tax increases, and since then further phased tax rises, and three half-point jumps in base rates, have subtracted about 0.7 per cent from disposable income. The programme of tax rises has now been almost fully implemented, but there will be a final burst in April, when mortgage and married couples' relief is reduced from 20p to 15p in the pound. This will take a further 0.5 per cent out of the pockets of our chosen family, making the total swing in the policy impact about 2.5 per cent in exactly a year.
This is a large dent in anyone's language and it is therefore not too surprising that the growth rate in retail spending has dwindled to almost nothing. But does this mean that the policy tightening in the past 12 months was misguided? It is easy to see how a Conservative backbencher up for re-election might have come to this conclusion, but the rest of us should be more circumspect.
Precisely the same people who were calling most vociferously for a sterling devaluation in 1992 (mostly on the Euro-sceptic wing of the Tory Party) are those who are now complaining about the fiscal and monetary tightening during 1994. But without this tightening in domestic policy, the devaluation would have given the economy such a huge boost that inflation would already be running well above the Government's 4 per cent target ceiling.
Inflation pressures on the increase
As for recent growth rates in the retail sector, the export sector and the manufacturing sector - retail spending is now growing at about 1 per cent, down from a peak of 4 per cent. Exports continue to power ahead, and in recent months have been growing at an annual rate of more than 20 per cent. This mixed bag has left the whole of the manufacturing sector expanding at just under 4 per cent, down from a peak of 7 per cent in the first half of 1994.
Clearly, in the absence of the slowdown in the retail sector, the growth in exports would have been sufficient to have produced a severe overheating in the economy by now. And even with the setback in retailing, inflation pressures are definitely starting to rise.
Stripped of all seasonal items, the three-month annualised inflation rate in core producer prices is now above 5 per cent, and for the first time these producer price rises are beginning to stick at the retail level. Measured on the same three-month annualised basis, the core retail price index is rising at 3.3 per cent, clearly in the top half of the target band, which is intended to be a "forbidden" zone.
Looking back, it is even more clear than ever that the February 1994 cut in base rates was a mistake, and that the onset of monetary tightening last September came not a moment too soon to head off a damaging rise in inflation.
Looking ahead, the great unknown is how far retail spending will continue to weaken. Will it go so far as to drag the economy into a renewed recession? This seems most unlikely. As already explained, consumer weakness in recent months has coincided with a bunching of fiscal and monetary measures that have taken about 2.5 per cent out of disposable income. Once this has been absorbed, the strength of the labour market should lead to renewed growth in real disposable income, probably at a 2 - 3 per cent annual rate, and the consumer will recover.
The slowdown in retail spending in the second half of last year will then be seen for what it was - a necessary pause to create room for export growth, to put the lid back on inflation, and to make the recovery more sustainable.
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