When it comes to inflation figures, trust your intuition

When intuition says one thing and the figures say another, trust intuition. In the past few days it has gradually seeped through to the markets that the UK economy has been growing faster than the figures initially suggested. As a result, expectations for a post-election rise in interest rates have shifted up a notch: the issue is whether, a month from now, they will be half a percentage point higher or merely a quarter, while by the end of the year it is beginning to look as though they might be one percentage point up.

There are several reasons for this change in perception. One is that the rise in house prices, always a lead indicator of UK consumption, seems to have shifted up a gear in the first months of this year. Another is the clear evidence of a rise in the rate of increase in earnings. And while the GDP figures do not give any cause for concern, some good work by Lehman Brothers demonstrates they may be wrong. Michael Dicks, an economist, looked at the way in which initial estimates of GDP have consistently understated what happened. Just as the statisticians always seem to find that invisible earnings are higher than they first thought, so there always seems to have been more economic activity than the numbers initially catch.

If this is right, the implication would seem to be that not only is the economy growing much faster than was previously thought: it is also closer to full capacity. It follows that the new government will have to tighten policy quickly and since it cannot, for political reasons, do much on the fiscal side, monetary policy will have to bear the burden.

There is a lot in this argument. The core of the problem is that while we have good figures on the manufacturing side of the economy, we have relatively poor ones on the service side. Yet services are much larger, and therefore more important. You can see some of the strain in service sector prices. Until this time last year the rise in UK service sector prices was much the same as those of France and Germany (left-hand graph). But since then UK service prices have climbed steadily. The rise in sterling, which is holding down the prices of manufactured goods, does not help much on the services side.

The rise in service sector inflation seems to have been associated with a surge in service sector demand. The best leading indicator of the pressure of demand in manufacturing is the purchasing managers index. Since last July the authorities have been collecting data for the service sector too and the first results were published a fortnight ago. The data is split into different categories but Goldman Sachs has calculated a single index from this and compared it with the manufacturing side (right-hand graph). As you can see, since the beginning of this year there seems to have been a sudden spurt in services, while manufacturing has remained flat. This is further evidence that growth is shifting up a gear at the moment.

So the figures are catching up with what is actually happening and the conclusion that interest rates will have to rise, maybe quite sharply, after the election is reinforced.

But that is the short-term, market response. Financial markets sleep, drink and eat interest rates. The wider issue, and it is one which we will hear much more of during the next five years, is whether our predominantly service economy can increase its output at a faster rate than in the past, and if so, how?

Capacity is probably a more flexible concept in services than in manufacturing. The lags are certainly shorter, for the unit size of investments, and hence the lead time in getting investment into service, is shorter. So it should be possible for service industries to respond to increased demand more easily than manufacturing. A rise in demand for services, too, is less likely to suck in imports, because a lot of services cannot be imported.

That means that if there is increased demand which cannot be met by increased output, it has to show in higher prices rather than increased imports. During the late 1980s boom, soaring imports acted as a buffer, checking the rise in prices of domestic goods that would otherwise have taken place. But that does not answer the capacity questions posed above. There almost certainly is no simple, single answer. It is possible, though, to sketch some parts of a complex one. We know that, provided we approach capacity slowly, we are more likely to be able to stretch it. A slow fall in unemployment is much less likely to lead to a sudden rise in pay rates than a rapid one.

We know too that it takes quite a long time for increased investment in service industries to lead to increased productivity.

One of the great puzzles of the past 10 years has been the tiny return that seems to have been generated by all the investment that companies have made in information technology. Part of the explanation may be that the investment has resulted in better quality of service and this is not caught in the output stats. But part of the explanation may simply be that it takes a while for new investment in any industry to improve productivity.

Our economy is going through a very rapid structural change. Whole new industries are springing up, while existing ones are transforming their way of business. I think it is perfectly possible that we will see radical improvements in productivity of service industries, which will enable some increase in the "natural" rate of growth of the economy.

But I doubt whether it is possible to do much to foster that growth, for that has to be a bottom-up, market-driven process. The best thing the authorities can do is to provide a stable macro-economic environment which comes back to that next rise in interest rates.

Start your day with The Independent, sign up for daily news emails
News
Sir David Attenborough
people
Life and Style
Young girl and bowl of cereal
food + drink
Arts and Entertainment
Henry VIII played by Damien Lewis
tvReview: Scheming queens-in-waiting, tangled lines of succession and men of lowly birth rising to power – sound familiar?
News
news
PROMOTED VIDEO
Sport
football
Arts and Entertainment
'The Archers' has an audience of about five million
radioA growing number of listeners are voicing their discontent; so loudly that even the BBC's director-general seems worried
News
i100
Life and Style
David Bowie by Duffy
fashion
Arts and Entertainment
Hell, yeah: members of the 369th Infantry arrive back in New York
booksWorld War Z author Max Brooks honours WW1's Harlem Hellfighters in new graphic novel
News
advertisingVideo: The company that brought you the 'Bud' 'Weis' 'Er' frogs and 'Wasssssup' ads, has something up its sleeve for Sunday's big match
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Market Research Executive

£23000 - £26000 per annum + Benefits: Ashdown Group: Market Research Executive...

Recruitment Genius: Technical Report Writer

£25000 - £35000 per annum: Recruitment Genius: A Technical Report Writer is re...

MBDA UK Ltd: Indirect Procurement Category Manager

Competitive salary & benefits!: MBDA UK Ltd: MBDA UK LTD Indirect Procurement...

Recruitment Genius: Web Developer - PHP

£16500 - £16640 per annum: Recruitment Genius: This fast growing Finance compa...

Day In a Page

Isis hostage crisis: Militant group stands strong as its numerous enemies fail to find a common plan to defeat it

Isis stands strong as its numerous enemies fail to find a common plan to defeat it

The jihadis are being squeezed militarily and economically, but there is no sign of an implosion, says Patrick Cockburn
Virtual reality thrusts viewers into the frontline of global events - and puts film-goers at the heart of the action

Virtual reality: Seeing is believing

Virtual reality thrusts viewers into the frontline of global events - and puts film-goers at the heart of the action
Homeless Veterans appeal: MP says Coalition ‘not doing enough’

Homeless Veterans appeal

MP says Coalition ‘not doing enough’ to help
Has The Archers lost the plot with it's spicy storylines?

Has The Archers lost the plot?

A growing number of listeners are voicing their discontent over the rural soap's spicy storylines; so loudly that even the BBC's director-general seems worried, says Simon Kelner
Human skull discovery in Israel proves humans lived side-by-side with Neanderthals

Human skull discovery in Israel proves humans lived side-by-side with Neanderthals

Scientists unearthed the cranial fragments from Manot Cave in West Galilee
World War Z author Max Brooks honours WW1's Harlem Hellfighters in new graphic novel

Max Brooks honours Harlem Hellfighters

The author talks about race, legacy and his Will Smith film option to Tim Walker
Valentine's Day cards: 5 best online card shops

Don't leave it to the petrol station: The best online card shops for Valentine's Day

Can't find a card you like on the high street? Try one of these sites for individual, personalised options, whatever your taste
Greece elections: In times like these, the EU has far more dangerous adversaries than Syriza

Greece elections

In times like these, the EU has far more dangerous adversaries than Syriza, says Patrick Cockburn
Holocaust Memorial Day: Nazi victims remembered as spectre of prejudice reappears

Holocaust Memorial Day

Nazi victims remembered as spectre of prejudice reappears over Europe
Fortitude and the Arctic attraction: Our fascination with the last great wilderness

Magnetic north

The Arctic has always exerted a pull, from Greek myth to new thriller Fortitude. Gerard Gilbert considers what's behind our fascination with the last great wilderness
Homeless Veterans appeal: Homeless in Wales can find inspiration from Daniel’s story

Homeless Veterans appeal

Homeless in Wales can find inspiration from Daniel’s story
Front National family feud? Marine Le Pen and her relatives clash over French far-right party's response to Paris terror attacks

Front National family feud?

Marine Le Pen and her relatives clash over French far-right party's response to Paris terror attacks
Pot of gold: tasting the world’s most expensive tea

Pot of gold

Tasting the world’s most expensive tea
10 best wildlife-watching experiences: From hen harriers to porpoises

From hen harriers to porpoises: 10 best wildlife-watching experiences

While many of Britain's birds have flown south for the winter, it's still a great time to get outside for a spot of twitching
Nick Easter: 'I don’t want just to hold tackle bags, I want to be out there'

'I don’t want just to hold tackle bags, I want to be out there'

Nick Easter targeting World Cup place after England recall