Base rates rose from a low point of 5.75 per cent in the autumn of 1996 to 7.5 per cent in June 1998, and the exchange rate rose by almost 30 per cent over a similar period. If we combine these interest-rate and exchange-rate changes into a single Monetary Conditions Index, with appropriate weights based on the impact of the different components on GDP growth, the overall tightening in monetary policy was equivalent to a jump in interest rates across the whole yield curve of some 5 percentage points.
Of course, many commentators have argued that this degree of monetary tightening would have been unnecessary if the Chancellor had been willing to raise the burden of consumer taxation more significantly in his first two budgets. The old criticism of Nigel Lawson - that he relied too heavily on "one-club golfing" - was widely revived. But this argument always missed the fact that Gordon Brown's budgetary stance was in fact tightening markedly as a result of the maintenance of Kenneth Clarke's tough public spending regime. Largely because of this, the budgetary stance in fact tightened by 3 per cent of GDP between 1996/97 and 1998/99, one of the toughest phases of fiscal policy in recent times.
If the Chancellor had raised consumer taxes on top of all this, the contractionary effects would have hit the economy around the middle of last year, just when consumer and business confidence were on the point of outright collapse. Even as it was, the cumulative impact of a 5 percentage point tightening in monetary conditions, along with a 3 per cent of GDP shift in fiscal policy, could easily have tipped the economy into deep recession.
The fact that this scale of tightening was necessary to contain potential inflationary pressures demonstrates what a powerful head of steam had built up in the economy from 1995 to 1997. Given the inevitable uncertainties in judging the impact of even a small change in macro-economic policy on GDP, the likelihood of such a massive change proving just right was not overwhelmingly large.
Indeed, there was a very nasty moment last autumn when it appeared that a combination of the domestic policy tightening and the global financial crisis might induce a hard landing, bringing the consumer boom to an end in an all-too-familiar manner. Goldman Sachs calculated that the risk of recession was running as high as 40 per cent in the second half of 1998, a figure which has only been exceeded during the hard landings in the late 1970s and 1980s. Britain is still not entirely out of the woods, with the 15 per cent overvaluation of sterling now constituting the main recessionary threat. Nevertheless, the risk of recession has now fallen to little more than 10 per cent; far more comfortable territory.
If it turns out that the economy does indeed enjoy a soft landing, this will raise a crucial question - why did the consumer boom of the late 1990s not in the end trigger the usual hard landing as a result of the huge policy tightening necessary to control it? Was it simply that the boom itself was slightly less rampant than earlier episodes? Or was it just that policy makers happened to implement exactly the right dose of medicine this time, instead of killing the patient, as has happened in the past? No doubt both of these factors had a part to play, but there were other, more fundamental factors at work.
Superficially, it can of course be argued that the economy did not tip into a hard landing late last year because the Bank moved so swiftly to cut base rates when it realised that policy overkill was a serious risk. But this begs the prior question of why the Bank was able to move so quickly this time, when in the past it had usually been forced to keep policy much tighter in the early stages of a downturn.
Probably the new monetary control mechanism takes some of the credit here, since it seems to have been responsible for a decline in inflation expectations that provided a much improved backdrop for the Monetary Policy Committee to operate in. The professional skills of Eddie George and a committee dominated by genuine monetary policy experts (instead of the businessmen and trade unionists who could so easily have been appointed instead) were also vital. But, at a deeper level, the key factor was undoubtedly the surprisingly benign behaviour of the labour market.
In most previous phases of policy tightening, it has taken an age for wage inflation to come under control, so the monetary authorities have not had the option of reducing interest rates quickly at the beginning of the economic downturn. In 1998, it rapidly became clear that wage pressures were abating much earlier than usual, largely because bonus payments and overtime earnings headed downwards as soon as the economy started to slow down. The rate of increase in the average earnings index therefore declined from 5.7 per cent in June 1998 to 4.5 per cent at the year's end, despite the fact that there was no decline in basic pay settlements. This welcome flexibility in the labour market was crucial in allowing the MPC the luxury of turning monetary policy around on a sixpence.
The new flexi-labour market was also central in another respect. Normally, with wage pressures refusing to abate as GDP declines, firms are forced to shed labour in large numbers in order to protect their cash flow. The resulting rise in unemployment hits consumer incomes and consumer confidence, thus exacerbating the onset of the recession.
None of this happened during 1998. Despite the fact that business confidence collapsed, total employment continued to increase throughout the second half of last year, and (so far) the increase in unemployment has been less than would normally have been expected, given that GDP growth has almost disappeared in the last two quarters. With unemployment figures remaining reasonably reassuring, consumers held their nerve during the darkest hours last autumn, and this was vital in stabilising the economy.
Thus the flexi-labour market helped in two related ways - by triggering an early drop in wage pressures, thereby allowing the MPC to slash interest rates, and by protecting the consumer from the usual rise in unemployment at a critical psychological moment. Without these breakthroughs in labour market behaviour - ironically inherited in part from reforms introduced by Conservatives over two decades - Ken Clarke's economic boom might all too easily have ended in a familiar disaster.Reuse content