Why the Bank of England was right on interest rates after all

It is becoming clear that policy should have been tightened rather earlier - when the Bank originally wanted to - if present expansion is not to get out of control
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The Independent Online
So Kenneth Clarke was wrong and the Bank of England was right after all. When Mr Clarke blocked the Bank from increasing interest rates two years ago in summer 1995 the popular judgement was that he was proved right by subsequent events. The economy did seem to be growing more slowly and the rise did not seem to have been needed to slow it further. We all know that Mr Clarke was wrong to block the Bank from increasing interest rates in the run-up to the election; but the accepted wisdom has been that on that first occasion he was right. Indeed, even the Bank softened its line and tacitly admitted it had been wrong to press for such an early increase in rates.

Now we know the Bank was right. Last week, long after the event, the statisticians announced they had discovered the economy had been growing more rapidly than they thought. GDP is now 1 per cent higher than they estimated and most of the revisions refer back to 1994 and 1995.

To many of us this did not come as a great surprise. Statisticians have found it difficult to measure activity in the service industries and usually have to upgrade their estimates. Intuitively, it felt as though the economy was expanding quite fast even when the figures did not confirm that, but economists are trained to look at figures rather than go out and find out what people are saying and doing. Last week's revisions to the data show they should have believed their instincts rather than their screens.

At one level this is all good sport: it is nice to poke fun at economists earnestly analysing data that turns out to completely wrong. But it does carry less agreeable implications for future policy, because if policy was not tightened early enough, it will have to be tightened more now. We all knew interest rates should have gone up last winter, but the delay was only a few months, which is none too catastrophic. Now it is becoming clear that policyshould ideally have been tightened rather earlier - like when the Bank originally wanted to - if the present expansion is not to get out of control.

Or at least that is the new popular wisdom. Because growth has been faster than once thought and because the economy is now larger than thought, it is close to full capacity. It follows that growth has to be pulled back to its trend rate, 2.3-2.4 per cent, if there is not to be an inflationary boom. This is the background to the calls for Mr Brown to take steps in the Budget to cool the housing market and check the growth of consumption.

Anyone arguing this, though, ought just to consider one small possibility. Maybe the new data we are considering is just as flawed as the old.

The particular data here that are relevant are those for the capacity of the economy. In a predominantly manufacturing economy there is a clear limit to capacity: plants can produce a certain amount of output and if demand exceeds that, then there is a combination of a rise in imports and a rise in inflation as buyers compete for scarce products. But in a service economy capacity is a more elastic concept. Of course there are finite limits, but not only are these less clear-cut; it is also possible to increase capacity more quickly. Indeed with some service products, like computer software, capacity can be increased very rapidly and almost infinitely.

Not only is the ceiling on capacity softer than before; it is also at least possible that it may be growing faster than was previously thought. The historical growth rate of the UK economy has been around 2.3 per cent, though in the 1980s it actually grew at 2.5 per cent. If you take 2.3 per cent and start from 1990, you can show that we are already at full- capacity now. Have a look at the graph, derived from some work by Goldman Sachs. If the old data had been correct there would still be some spare capacity, though the gap would be narrowing. Allow for the revisions to the data and we are already hitting the 2.3 per cent trend line drawn by Goldman.

On the other hand, if the underlying growth capacity had risen to the 2.6 per cent trend line that I have drawn in, there would be some spare capacity even allowing for the new evidence on growth.

Which view is right? It matters for policy. If the former is correct there is a serious and immediate problem. If growth is not slowed quickly we will run into an inflation problem very soon. But if the latter is correct, then, while growth will have to be checked over the next 18 months, there is less of an immediate danger.

There is certainly some problem, for consumption is rising very rapidly (witness the figures yesterday) and the housing market has an inflationary fizz to it. Further cause for concern comes from the money supply figures, also released yesterday, which show broad money rising at an annual 11 per cent. If you let money supply rise that fast you are going to get a housing boom. So whatever view you take on capacity, there is a case for higher interest rates.

But there is also quite a bit of evidence that there is no general capacity shortage yet. Unemployment has come down sharply, but the past three months have seen a modest decline in the rate of earnings growth, not a rise as you might have expected. What seems to be happening is that the demand for labour is pulling back into the labour market people who had become discouraged from seeking employment, like middle-aged women and early- retired men. This has enabled firms to carry on hiring without pushing up wage rates too much. There are specific labour shortages but not on a sufficient scale to lead to a general surge in pay rates.

Nor is there a problem on the balance of payments. True the very last monthly figures did show a jump in imports, but the current account was in solid surplus during the first three months of the year. Given the rate of growth of the economy over the past three years you would expect to see some sign of a deterioration during this time. But in fact the current account has moved from deficit to surplus. There may be a problem in the future but there is little evidence of it now.

Given the boom/bust history of recent years there is no cause for complacency. This is the stage of the cycle where we get things wrong. But given the scale and duration of the expansion, now in its sixth year, things appear quite benign - and would have looked even more benign had the Bank won that little spat with Mr Clarke two years ago.

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