The rise and fall of interest rates
Sunday 01 February 1998
First, the immediate question of interest rates. The background is an economy that has been growing well above its long-term trend and which is showing signs of strain, but which may suddenly be slowing of its own accord. The signs of strain are most obvious in the balance of payments, which was running in surplus for most of last year but started to slither into deficit in the final three months. It has also been evident in earnings, where the annual rise is nudging towards 5 per cent. And it is evident in prices, more in prices of assets (houses, shares) and services than in goods, but a concern none the less.
Against this is a smaller pile of evidence but a lot of worries. There may not be much actual slowing yet, but manufacturers and, in particular , exporters are feeling glum. We know that the East Asian crisis will knock something like half a percentage point off growth this year, and will also exert downward pressure on world prices in general - so there will be deflationary forces from there. And there is a nagging sense of foreboding that at some stage soon even the US economy will turn down, removing an enormous engine of growth from the world.
So had the monetary committee simply been looking at the UK economy, it would probably have little difficulty in concluding that it ought to jack up interest rates a bit further. Its formal remit is to get underlying inflation as close to 2.5 per cent as possible and we are still above that level. Even allowing for the lags between changes of interest rates and the impact on inflation - lags that are long, elastic and uncertain - the prudent thing would be to nudge rates up.
The trouble is that the committee cannot look at the UK economy in isolation, and there are now quite serious risks that the world economy will turn down sharply in the second half of this year. If that is likely, why not allow a slowing world economy to damp down things here?
My guess, for what it is worth, is that the committee will indeed push rates up one more time, but with the understanding that they will be prepared to cut interest rates swiftly if the economy does indeed slow down. How it can get that message across to the markets we will have to see.
But of course in the broad span of world events the decision over a quarter of a percentage point on interest rates by a few people sitting round a table in the Bank of England is not really very stirring stuff. It is the underlying situation of both the British economy and the world economy that makes it interesting.
Have a look at the graph, which shows what has happened to inflation here since the last war. There was, as you can see, a period of post-war disruption as price controls and rationing were dismantled, but the fixed exchange rate system kept inflation under control until 1972. There then was the great 1970s inflation catastrophe, corrected during the early 1980s under the discipline of monetary targets. But when we relaxed those, up shot inflation again, to be controlled first by ERM membership (a fixed exchange rate system again) and then by the present method of inflation targets.
There seem to me to be two powerful messages from this graph. The first is that you have to have an anchor, but any anchor - exchange rate, money supply or inflation - will do. The second is that before 1975 the trend of inflation was clearly up and since then the trend has been equally clearly down.
We are, for the foreseeable future, going to go on having some form of anchor, and I would be surprised (though this is more contentious) if the long-term trend of inflation were not to continue downwards for the next decade, maybe longer.
Lay this long-term perspective on inflation over what seems to be happening to the economy now. What we are seeing is a cyclical boom, which may be about to come to an end, in an era of long-term disinflation. This is a new experience for many people. The boom we most remember, that of the late 1980s, led to a surge in inflation (though nothing like the inflation of the 1970s) because it took place when there was no anchor. The present boom is much more like the booms in the 1950s, when prices were restrained by the need to watch the exchange rate, but even then there was an incipient tendency towards higher inflation. Now there isn't. In fact the present period has more in common with the boom in the south of England during the 1930s when they built all those semi-detached houses along the "arterial" roads.
This has not been a falling-price boom, but we are moving fast in that direction: towards a world in which people get a large part of their rise in living standards through lower prices rather than higher wages.
This will be very, very different from all our past experience. For companies it means becoming accustomed not just to being unable to sustain price increases, but operating in a climate where prices come down, and down, and down. The experience of the airlines (and even more dramatically, the electronics producers) over the past decade will become the norm. I do not know whether sterling's present strength will be sustained for long, though I think it will go on longer than the market at present reckons. But I would advise any company in the export business to work on the assumption that sterling will stay strong because that is the only safe assumption to make.
The result will be continuing, steady, relentless structural change in the economy. Companies in sectors that have been tending to "downsize" will continue to be squeezed and will be surprised (as they are now) at reports that the economy is booming. And companies in expanding areas will find themselves expanding production, but probably not increasing their prices and maybe even reducing them. You can catch a glimpse of this in the economy at the moment: most manufacturing is under pressure and finds it ridiculous that the Bank should be considering putting up interest rates still further; but most services are booming and at least understand the case for higher rates.
Are there bigger cyclical implications for us from the present conundrum at the Bank? Is the next cycle going to be different - bigger, smaller, longer, deeper - than the last?
I don't think it is possible to answer those questions at all yet. The lessons that can be extracted will be more modest. It will be fascinating to see whether the world economy is so integrated that a regional crisis can have a grave global impact: do tails wag dogs? It will be interesting to see how responsive our own economy is to interest rate changes. If, most importantly, rates go up next week and then - come the summer - the economy is going down fast, will a series of cuts in interest rates through the autumn jack up demand fast enough? Will inflationary pressures by then have subsided sufficiently to allow that to happen?
Well, we will have to see what the Bank does decide. The one thing I am sure about, though, is that if they do put rates up they will have to be prepared to cut them sharpish if things head south.
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