What keeps the hawks and doves flitting about

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The Independent Online
THE FURORE about the decision last week by the Bank of England Nine to spring a quarter-point interest-rate rise on an unsuspecting nation can only intensify after the revelation in the newly published minutes of the May meeting that the majority in favour of no move had increased since April - and, moreover, that one member had voted for a cut.

For the simple-minded folk in the City and elsewhere trying to understand how monetary policy is operating in the new regime, it is confusing enough. For the constituency of manufacturers, unions and politicians who think the cost of borrowing and the pound have been too high for too long, it almost beggars belief. How can policy be so "finely balanced", in the Bank's phrase, that members of the MPC can hop from the doves' perch to the hawks' perch, or vice versa, and back again within the space of a month or two.

The Bank's analysis of the forces it needs to respond to in order to keep inflation on target over the medium term has actually been far more stable than the MPC's voting pattern. For more than a year the quarterly Inflation Report has forecast that inflation will remain very close to its target in the short-term but will be on a firm upward path by late 1999 - the delayed but inevitable response to Kenneth Clarke's failure to increase the cost of borrowing as the economy started its mini-boom before the general election.

As soon as Gordon Brown stepped into his new office in May 1997 he took the necessary action, raising rates himself then handing over the reins to the new MPC, which opted for another four increases between then and November. It is since then that the committee has become increasingly divided over whether it needed to do more to meet the inflation target.

There are three key ingredients in the mix of evidence that has had the committee members veering from one direction to another since the new year. One is the weakness in manufacturing and the export sector of the economy as a result of the strong pound, reinforced by tentative signs of a slowdown in the consumer and service sectors. Manufacturing is stagnant and business surveys suggest it will weaken further. Meanwhile some bits of the service economy - especially retailing - are also cooling off.

The second issue is the continuing strength of the pound which, confusingly, cuts both ways. The longer it stays strong, the bigger the downturn in the export-oriented part of the economy is likely to be. On the other hand, overvalued exchange rates typically fall sharply at some point, bringing in their wake inflationary pressures via higher import prices.

The third element is the tight jobs market. Compared to past business cycles, the pick-up in earnings has been subdued. Even so, for the South- east generally, certain industries like financial services, and people with certain types of skill like computer programming or bricklaying, there is essentially full employment. Private sector wage inflation has started to reflect this, but there is no clear consensus as to whether it will continue on its steep upward trend, or reverse it if the recent rises turn out to reflect one-off bonuses rather than an underlying increase.

The evidence on these separate elements has not really changed very much since the New Year. Just as it does around the turning point of every cycle, the economy has generated a lot of mixed evidence. Those representing particular groups, such as exporters or northern engineering workers, see the signs closest to home most clearly, and find it impossible to understand why the MPC fat cats closeted in the splendour of Threadneedle Street do not see the world their way. (Curiously enough, the constituency arguing the case for higher interest rates this year has been neither as large nor as vocal, but those of us who belong to it are almost certainly all southerners having to pay more for our cappuccinos and home improvements.)

Yet, step outside a single world-view, as the MPC's members are supposed to do, and it is easy to see the near-impossibility of combining all the arguments in a single and consistent decision with utter confidence. Anybody who claims to be completely sure about the right policy step at the moment is a menace.

There are two long-term problems in setting interest rates that go deeper than the immediate, if pressing, question about what is needed at this stage of the cycle to keep inflation on target. The Bank's job is to get the level of rates that will keep the measured inflation rate, an economy-wide average, around 2.5 per cent. But this task glosses over the question as to how a single interest rate can meet the needs of the separate parts of a structurally divided economy.

The answer, of course, is that it can't. But that implies a need for both politicians and MPC members to be clear in their own minds about how they weigh the importance of the boom-prone and bust-prone parts. How much does each contribute to jobs, current output and potential future growth? If traditional low-value manufacturing is in decline, what will replace it and how is that decline to be managed? These questions are almost never made explicit in the debate.

The second long-term point is that the Bank of England's decisions about short-term interest rates have an unpredictable and possibly small impact on the real long-term interest rates which actually determine economic activity and prosperity. A timely new paper from Merrill Lynch, the investment bank, shows that while nominal long-term rates, measured by the yield on government bonds, have varied enormously since 1950, and remain much higher than the long-run historical average, the real, inflation-adjusted yield has always tended to return to around 3 per cent - irrespective of both the inflation rate and the level of government debt.

The paper finds that the one thing that has a big impact on real yields is demography, via the quantity of private saving as the average age of the population changes. Already, there are more retired people in Europe than ever before, and this is going to increase. Relative to the number of workers in future, the amount of capital will be high - the relative abundance of capital compared to labour across the developed economies is likely to make capital cheaper and therefore interest rates lower. The second chart shows Merrill Lynch's forecast for the likely path of the real interest rates in the UK.

The moral is that the Bank of England can influence the amount by which interest rates deviate from such long run trends, and how well they do this will determine their success in meeting the inflation target - and the level of unemployment in the meantime. What they can not do is alter the structure of the economy against which they have to set rates.