The temptation to change tack must be resisted

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The Independent Online
Will Hutton's new book* claims that Britain is a 40:30:30 society - 40 per cent employed and secure, 30 per cent employed but insecure about the future, and a 30 per cent underclass. He may be right, but another segregation in our normally cohesiv e nation may be equally important. At present, we are living in a 10:60:30 macro-economy.

The first slice has never really emerged from recession, and is now moving down again. The middle slice has clearly emerged from recession, but its growth rate is no better than average. Meanwhile, the third slice is enjoying its most intense boom in twodecades.

Coping with this split is rapidly becoming the largest headache facing the authorities as they wonder whether to raise base rates further at their next monthly monetary meeting on Thursday. Should they be mainly influenced by a desire to help the sluggish sectors, or by the inflationary pressures now emerging from the buoyant part of the economy? And is there any way of dampening the latter while helping the former?

The sectors in the doldrums are those particularly sensitive to interest rates and the willingness of consumers to borrow - i.e. housing, consumer durables and cars. The decline in base rates to 5.25 per cent in early 1994 just about managed to kick-start these parts of the economy, but the recovery was tentative.

Even before the Chancellor sanctioned the first base rate rise in September, the talk of rising interest rates had been enough to shatter confidence. Housing turnover and new car sales have been drifting downwards since the middle of last year. New orders for the construction industry are down about 20 per cent on a year ago, and tender prices in the building industry - previously a good lead indicator of economy wide inflation - have suddenly collapsed. No wonder that companies in these sectors are living in dread of more base rate increases.

In stark contrast, at least 30 per cent of the economy - most of the manufacturing sector and a chunk of the services sector that is exposed to domestic manufacturing or the export market - is enjoying no ordinary boom. The reported rise in manufacturingoutput shown in the CBI survey in the final quarter of last year was equal to that seen at the peak of the boom in the late 1980s. The January survey's reading for export optimism has been exceeded for two short periods only in the survey's history.

Clearly, the buoyancy of manufacturing is derived almost entirely from the stunning performance of UK exports since the 1992 devaluation. Ever since the European markets emerged from recession in mid-1993, British exporters have shown a rare ability to increase their share of a rising market, and export volume jumped by about 8 per cent last year.

The trend rate of growth in manufacturing output is running at an annual rate of about 4 per cent, down from 6-7 per cent in the early part of 1994. With the middle slice of the economy (the public sector and domestic services) growing at about 2-2.5 percent, and the interest rate sectors actually declining, the initial GDP estimate for the fourth quarter of 1994 showed growth of 0.8 per cent (3.2 per cent at an annual rate).

If this figure proves accurate, the authorities might be justified in leaving interest unchanged on the grounds that the economy is cooling from the 4 per cent growth rates seen in 1994. However, the recent pattern has been for GDP estimates to be revised upwards, and this will probably happen again.

The CBI, using its survey as a basis for estimating output, reckons that manufacturing production rose by 1.7 per cent in the fourth quarter of 1994, considerably more than twice the rate implied by official statistics.

So while the economy is offeringchequered evidence of strength in different sectors, the overall picture is one in which overall growth remains far too strong. This is now showing clearly in inflation figures. Food price inflation bottomed a year ago; other goods' inflation has been rising since last spring; and inflation in services, which usually tends to lag, has stopped falling.

Overall, the running rate for core inflation has jumped from about 0.1 per cent per month in April to 0.3 per cent now - a figure not compatible with the Government's aim of keeping inflation in the bottom half of its 1-4 per cent target range until the next general election.

Inflation is now the prime - officially, the only - objective of monetary policy, so should be all thatdetermines base rate changes. The one acceptable reason for leaving rates unchanged is therefore that the authorities believe they have done enough to slow the economy and check inflation.

Perhaps they have, but the financial markets are not convinced, and they will be unforgiving of a Chancellor who claims that he will bias inflation against inflation risks, but then shrinks from taking the necessary action.

Where does this leave the balance of the economy between expanding and declining sectors? This is obviously of more than passing political interest, since the rise in exports is the other side of the "no feel good" coin. What the economy is doing at present is producing goods for foreigners to consume - the very inverse of what it did when our own electorate felt so good in the 1980s.

But we should recall that this shift in the balance of the economy has been something the UK has been attempting to achieve for decades. The fact it is happening now is no accident, but is a tribute to the mix of policy that has been successfully pursuedsince the tough Lamont and Clarke Budgets of 1993.

Furthermore, the increase in price inflation in the manufacturing sector relative to the service sector is part of the domestic adjustment that is necessary if relative profits in the export industries are to rise, encouraging resources to shift permanently towards them.

What could the Government do if it wished to reverse some of these beneficial long-term effects for near-term electoral advantage? If it could wave a magic wand and push the exchange rate higher, this would dampen the export sectors, and reduce inflationpressures without raising interest rates. With the economy slowing, there might even be sufficient excuse for tax cuts in 1996.

There is no such magic wand, but one option, apparently favoured in some economic departments outside the Treasury, would be to unwind the successful policy mix of 1993-94 by raising base rates sharply now, and cutting taxes later. Sterling would probably rise as the markets responded to the expectation of permanently higher interest rates. A higher exchange rate would be welcomed by Conservative Central Office, since it would allow the electorate to raise consumption at least in line with UK output, perhaps more if imports surge.

But such a reversal of the present policy mix would at the same time threaten that rarest of British specimens, an export-led recovery. Interest rates should indeed be raised, but only by the minimum amount necessary to keep inflation within its target range. Even that might push sterling higher for a time. But to go further in order to "buy" some pre-election tax cuts would be a deliberate act of policy vandalism.

*The State We're In, Cape, £16.99

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