Hamish McRae: Why King is wrong to be hawkish on interest rates

In a speech on Tuesday evening, he provided a very thoughtful insight into the medium-term outlook for the UK economy. His starting point was that the business cycle still existed. Since 1992, the UK economy had experienced a Great Stability: there was a "nice" decade, with "nice" standing for non-inflationary, consistently expansionary economic growth.

This had led to the idea that it was the responsibility of the Bank to try to maintain it. But he rejected this for two reasons. First, there are shocks to demand and the Bank does not know enough about the effect of these to be able to respond appropriately at the time. And second, there are longer-term influences that make it difficult to know what is happening to the growth potential of the economy. These include the influx of workers from Eastern Europe, which has doubled the growth of the supply of labour, and the impact of IT investment.

This posed two questions. One was whether the Great Stability would continue. Mr King thought this unlikely. There was always the risk of a sharp correction - I love that word "correction" - in the growth of consumption, and the things that had boosted consumption now seemed to be going into reverse.

These included the impact of China and India on the global economy, first cutting the price of traded goods and services and now boosting the price of raw materials and energy. Initially, consumers in the West benefited from lower prices; now they are being squeezed by more expensive energy. There was little the Bank could do about the consequent rebalancing of the economy away from consumption and towards investment and exports.

But the Bank did have to decide what to do about interest rates and Mr King set out a series of arguments for the "hawks". Inflation was above target at 2.4 per cent (after only 1.1 per cent a year ago) and the Monetary Policy Committee had been surprised by this, as well as by the suddenness of the slowdown. Part of the responsibility for the rise in inflation was oil, but only half was accounted for by that. Much of the rise in inflation was the result of higher charges for services including health, education and financial services. In the light of all this, it was not reasonable to expect monetary policy to be able to deliver smooth growth of output. Its job was to deliver low and stable inflation.

That is a compressed and simplified account of the governor's speech but, I hope, a fair one. Its main theme - that we should not ask monetary policy to do things it can't - is surely absolutely right. There did, however, seem to be two unspoken, or at least half-spoken, messages.

One was concern about the inflationary contribution of the Government itself. Of course, the Governor did not criticise the public sector as such. But his comments on service-sector inflation were consistent with that. There can be little doubt that the falling productivity of the public sector is one of the inflationary forces. That shows explicitly in higher charges for such services where charges are levied (for example, the London congestion charge) or implicitly in higher taxation. The Government is not responsible for the entire rise in service industry charges by any means but it is not helping.

The other message was that the Bank should not cut interest rates to counter falling demand but rather focus on inflation. As a general principle, that is fine, but applied to the economy now I think there are dangers.

Have a look at the charts. They come from the most recent Bank of England Inflation Report, published in August, and follow the very helpful Bank pattern of showing probability of particular outcomes in the form of a fan. The highest probability is naturally shown by the blacker bits in the centre. Then, the market expected a modest decline in interest rates (first chart). This was taken as a basis for the Bank to calculate the likely trend in output (second chart) and inflation (third one).

We will have to wait until next month to see how the Bank economists have changed their views but they may well be a bit more pessimistic on both: output will be lower and inflation higher. But the inflation one won't have changed radically. As you can see, the outlook for inflation was really quite benign, at least through to the end of 2006. The outlook for growth, on the other hand, we know to be too optimistic. Growth this year is not going to be 2 per cent but something more like 1.6-1.8 per cent. Indeed, over the past 12 months, growth has been the slowest since 1992, suggesting that the Great Stability may indeed be drawing to an end.

The objection to Mr King's argument is not one over the principle that monetary policy should not be responsible for maintaining smooth growth of output, but the practice. (Actually I don't think the Bank should claim quite so much credit for the smooth ride through the 2000/ 2002 downswing. Much of that was down to the strong counter-cyclical fiscal policy.) No, the objection is that the rising interest rates have done the job they had to do, which was to end the housing boom. They were not increased because of overall inflationary pressures, which were very mild a year ago. Now that house prices are stable, the present level of rates is no longer needed.

So what the Bank should do is to take the same risk on the downward move of rates as it took on the upward side. Just as it was prepared to increase rates when inflation was below target, so it should be prepared to cut rates when inflation is above it.

The surprise this year on inflation, surely, is not that it has risen a bit but by how little it has risen, given that oil prices have doubled. The downward pressure on manufactured goods prices from China will continue. Increasingly this will be reinforced by downward pressure on the price of traded service industries. The problem in the UK is in the non-traded service sector and a lot of that is in the public sector, which is immune from monetary policy.

None of this is to say that rates should come down further next month. I think we need more evidence of what is happening to the labour market (unemployment numbers up a bit more yesterday), wage growth (still benign) and of course consumption, before calling for further cuts. We should not be frightened of a year or two of below-trend growth, which we are going to get anyway. But the balance of risk, surely, is that below-trend growth will slither down further. And it if does, then the Bank would be wise to react asap. I'm worried that our governor is not worried enough about that.