Will the Chancellor overrule the Bank again?
Monday 11 December 1995
The Treasury Select Committee took evidence on the Budget last week from Bank of England and Treasury officials. Their response to MPs' questions on these occasions is usually pretty circumspect, just in case they say anything that might discomfort the Chancellor, who is due to give his own evidence to the committee on Wednesday. This year, with a notable exception, the responses were even more stilted than usual.
Certainly, no one was willing even to twitch an eyebrow in the direction of monetary policy, in view of the imminence and sensitivity of the Treasury/Bank monetary meeting, due on Wednesday. Nevertheless, the officials managed overall to give me the impression, rightly or wrongly, that there is no great enthusiasm at either end of town for a large cut in base rates at the moment - though the Chancellor may, of course, once again overrule all of them.
The notable exception to the norm of low-key circumspection was the Governor of the Bank himself, who did a lot more than twitch an eyebrow about the Chancellor's decision to leave base rates unchanged last May. In fact, he was quite disparaging about it, as the rules of these encounters go, and it will be interesting to watch for any retaliation by the Chancellor this week. (I am stubborn enough still to sympathise with the Governor, notwithstanding the extraordinary weight of evidence that appears to have piled up on the Chancellor's side of the debate in recent months.)
Mr George said that Mr Clarke had been "lucky" to find that a "dangerous" developing situation for sterling in the wake of the decision was rescued by a sudden change in trend for the dollar. He still believed that the Bank's advice to raise rates in May had been right, in the sense that the balance of probability then was that the inflation target would be missed with base rates unchanged.
In Mervyn King's words to a slightly bemused collection of MPs: "A forecast is a probability distribution." Or, in the more homespun words of the Governor: "The favourite does not always win the race." I am not sure whether Parliament and the public can be readily persuaded that it can sometimes make sense to have backed a loser but, since this is obviously true, I wish the Governor luck in his endeavour.
Mr George then went on to explain that he could only support an easing in monetary policy if he could be reasonably confident that future inflation would come in below 2.5 per cent, after taking account of the effects of the base rate cut itself. The Bank did not believe that this was the case when it published its Inflation Report in November, and they will probably recommend no change in base rates again this week. It is hard to tell whether Treasury officials will do likewise. Sir Terence Burns, the Permanent Secretary, made an interesting speech last week, in which he reported that "the 1995 Budget must have been one of the great Internet events yet seen in this country". Apparently, more than 200,000 "hits" to the Treasury's Budget site on World Wide Web have already been recorded. The thought of a city the size of Southampton desperately searching cyberspace for the Chancellor's missing tax cuts is alarming. Who are all these people who want to read the Treasury Red Book? Sadly, I have met all too few of them.
Anyway, when Sir Terence returned to earth, he made one point that could be important to this week's debate. "One consequence of the frailty of forecasts", he said, "is a tendency to be over-influenced by what is happening today - or rather what today's data are telling us happened a few months ago. To some degree we all suffer from this, no matter how hard we try." This sounds like someone who believes the current bout of weakness in the economy is just temporary, and indeed that it might already be almost over. Certainly, the pattern shown in the Treasury's Budget forecast envisages growth in GDP of 0.4 per cent this quarter, and then 0.8-1 per cent per quarter throughout next year. In other words, no further dip in growth will occur.
Most forecasters seem to agree with the Treasury that GDP growth will be running at 0.7-0.9 per cent per quarter from next spring onwards, but there is no agreement about what will happen in the immediate future. This may seem like a trivial point, but the first graph shows how important it is for the level of output in 1996. The Goldman Sachs forecast assumes that real GDP growth is only 0.1 per cent this quarter and 0.2 per cent next quarter, after which it follows much the same growth path as the Treasury's. Yet this difference is enough to produce a 1996 calendar year growth rate of 1.7 per cent for Goldman Sachs, compared with 3 per cent for the Treasury.
The main underlying difference in view relates to stock-building, as illustrated in the second graph. The long-term trend in the UK stock/output ratio is downwards, as companies become progressively better at matching supply with demand. In contrast to this long-term trend, the stock/output ratio has actually been rising sharply since mid-1994, and in recent quarters this has clearly been unintended by the company sector. The Treasury forecast assumes that companies will take a fairly relaxed view about getting rid of these excess stocks in the course of next year, in which case the stock/output ratio will only drift downwards, and will remain far above its long-term trend throughout 1996.
The Goldman Sachs view is that companies are becoming far more exercised about the need to shed stocks than the Treasury thinks, and that the downward adjustment in stocks will be much more abrupt. This view is substantiated by survey data which shows that companies have been keenly trying to reduce stocks for several months, but have so far not been able to get ahead of unexpected declines in final demand. The Treasury is clearly hoping that companies will not suddenly become impatient, but this seems optimistic - especially since a similar phenomenon is happening throughout continental Europe, which will hit our export markets at exactly the wrong time.
Colin Mowl, chief forecaster at the Treasury, told the Select Committee last week that base rates should not respond to the stock cycle anyway, since it would be over before the monetary effects came through. But a shortfall of 1.25 per cent in the average level of GDP next year, and of 2.25 per cent in manufacturing output, surely makes a large difference to the amount of spare capacity in the system (the "output gap"), and therefore to the inflation rate in 1997. There is no doubt that the chances of hitting the 2.5 per cent inflation objective at the end of this Parliament are increasing appreciably with every month of sluggish growth in the manufacturing sector - which was, after all, the only sector suffering from inflation pressure in the first place.
The Chancellor may want to wait for a few weeks for the UK to follow the Germans and Americans in cutting interest rates, or he might want to get in first this week. It would be hard to quibble with him this time if he felt impatient.
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