Wanted: a stand-off on interest rates

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Amid all the Government's political difficulties, the economy is doing rather well. Well enough, you might say, to place the Conservatives in a good position for the next general election.

Cynics may complain that this result has been achieved more by luck than judgement. It derives principally from the 'decision' to leave the ERM and cut interest rates. If anyone deserves credit for that, of course, it is George Soros.

But there is one cloud on the horizon and that is largely of the Government's creation - if the Government can be thought of as creating a cloud - and it is, once again, to do with interest rate policy, and once again to do with a George.

I refer to the increasingly powerful position of the Bank of England and its Governor, Eddie George. It is particularly fitting that the Bank's increase in power should become evident in its tercentenary year and the newly powerful, if not quite independent, Bank may serve the country well over the years. But it could cause real problems for this Government.

For under Mr George the Bank is setting out to be the sturdiest of inflation fighters. In many ways this is laudable. But why now, you may ask, when inflation is all but dead, rather than six, 15 or 20 years ago? It seems to continue the pattern of our leaders fighting yesterday's battles.

This is not how the Bank sees it. In its latest inflation report the Bank made it clear that it is worried that inflation may rise next year. In fact this has been its refrain ever since the report was first published. Meanwhile, of course, inflation itself has continued to fall.

True to form, a few days after the latest report the April inflation figures were published and they turned out to be about 0.5 per cent below the Bank's forecast.

This apparently does not perturb the Bank, because it argues that current inflation figures are of little or no relevance to inflation in the future, and that is its concern.

The problem with this approach is that, in its current frame of mind, the Bank seems to recognise the existence of only two states of the world - one in which inflation is already high, with obvious consequences for policy, the other in which it is in danger of being high 'in the future'.

While he is in this frame of mind, getting Mr George to agree to further rate cuts is going to be like drawing teeth.


This attitude of the Bank reminds me of those medieval tests in which a woman was 'ducked' in water to determine whether or not she was a witch. If she drowned, she was innocent. If she survived, she was clearly a witch and had to be put to death.

There is an argument, of course, that Kenneth Clarke should himself be thinking about raising rates now as a sort of pre-emptive strike. This can be argued from both a political and an economic view. Politically, the argument runs, the important thing is to have interest rates low and probably falling by the time of the general election, which will not be until 1996 or 1997. There is a better chance of achieving this safely if rates are put up now.

This argument is fraught with difficulties in the current situation. For a start, this time profile of nasty medicine first followed by relief later is already in place for fiscal policy. Further tax rises are planned for next year and for the year after, on top of this year's.

The Government has already paid the political price for this, but should be able to reap the reward in terms of tax cuts before the next election. It is not obvious that it either needs, or can afford, to engage in the same game with regard to interest rates.

Then, again, there is the position of Mr George. You can be sure that if Mr Clarke wanted to raise rates for political reasons Mr George would see his way to agreeing for economic reasons. So everything could be hunky-dory for a while.

But what about when the Chancellor wanted to cut rates again in order to win the political pay-off? Each quarter of a percentage point might be fought over tooth and nail, just as now. In other words, even putting interest rates up for (long-run) political reasons is not an attractive option now.

Nor are the economic arguments for a 'pre-emptive strike' all that good. The case for higher British rates is often made in comparison with the US Federal Reserve's pre-emptive strike earlier this year. Yet the two countries have been in quite different situations.

For a start, rates in the US came down to 3 per cent. Even after this year's painful rises, they are still 1 per cent below the current British level. Moreover, the economic expansion in the States is a good deal more mature than the UK's and, at the end of last year at least, was progressing at rapid pace. Meanwhile, the US fiscal tightening is much smaller than the British version.

If the UK is going to run into inflationary problems in the next year or so the prime reason will be a shortage of capacity, particularly in traded goods.

One of the worrying features of the British recovery so far has been the weakness of investment. There are now some encouraging signs that investment will pick up, but how would this stand after a pre-emptive strike on interest rates?

And what would the consequences be for the pound if we raised interest rates without yet any clear signs of inflation while German and other Continental rates were falling?

This would send all the wrong messages to business. In short, it would be a repeat of the abiding theme of the 1980s - when push comes to shove, investment and industrial competitiveness have to take the main burden of counter-inflation policy.

Moreover, it would send a dangerous message to Conservative backbenchers, already beginning to salivate over the prospect of tax cuts after the PSBR came in last year at 'only' pounds 46bn.

If they are forced to swallow a pre- emptive increase in interest rates, in the light of the Conservative Party's unpopularity they will be begging for tax cuts now to overlay the planned tax increases, or even for the tax increases to be rescinded.

That would be precisely the wrong combination of policies - easier fiscal and tighter monetary. Rather, Mr George should use his undoubted clout to secure further fiscal stringency, in the shape of expenditure cuts, and the real reaffirmation of the planned tax rises in exchange for a small interest rate reduction.

(Graph omitted)


But, with or without another rate cut, we should now be able to enjoy a period of broad interest rate stability - provided Mr Clarke is able to squash the idea of the pre-emptive strike. Indeed, there could be a sort of stand-off with Mr Clarke refusing to put rates up and Mr George refusing to support a cut. It would be a case of the irresistible force meeting the immovable object.

This would provide the basis for a few years of real economic success. The problem is that after so many horrors we in Britain cannot easily believe that the sky could be so clear - roughly 5 per cent interest rates, 2.5 to 3 per cent growth for several years and yet still only 2 per cent inflation.

Everyone seems to believe that, now inflation has been wrung out of the system, growth still has to be subdued to keep it out. Yet when you see a clear sky ahead it is sometimes better to believe the evidence of your eyes than to insist that there must be clouds ahead.

The author is chief economist at Midland Bank. Gavyn Davies is back next week.