Sunday, April 04, 2004
Too early to rise for the Bank
Posted by David Smith at 08:32 AM
Category: David Smith's other articles

Despite the declared aim of Mervyn King that meetings of the Bank of England’s monetary policy committee should be boring, this week’s promises to be the most interesting for many months.

By boring, the governor means predictable. Unlike some central banks, which take macho pleasure in springing surprises, the independent Bank has tried when possible to do what informed opinion has expected of it. The City is happy with this, and so are commentators, even though all of us have felt that nervous tension once a month at noon on Thursday, waiting to see whether the Bank has done what we said it would.

This time, however, such predictability is lacking. The City is split down the middle on whether there will be a rate rise this week. I would lean towards the MPC delaying an increase but would not want to bet on it.

The second area of unpredictability relates to the Bank itself. Since being granted independence in 1997, it has worked hard to explain how it goes about its business of setting interest rates.

It is not, in fact, that hard to explain. The MPC has a single target, that of achieving 2% inflation on the new consumer-prices index measure (2.5% on the old measure).

The main determinant of whether inflation is likely to go above or below target is the relationship between growth and spare capacity in the economy. If there is plenty of spare capacity — in the jargon, there is a significant “output gap” — then even very strong economic growth need not pose an inflationary threat.

If, on the other hand, growth is strong and there is little spare capacity, the Bank will raise interest rates to head off the inflation danger. That is the situation we are in at present. Growth is faster than the trend, or long-run rate, of 2.75%. The output gap, according to the Bank’s own analysis, is small. This argues for a gradual increase in interest rates to a neutral level, which probably means a rate of 4.5% or 5%.

Paul Tucker, an MPC member, described this process well in a speech last month. “If, as projected, output continues to grow above trend,” he said, “I for one would expect us to continue gradually to reduce the degree of stimulus to demand broadly in line with the take-up of slack in the economy and any consequent pick-up in inflationary pressures.”

Gradual is the operative word. The Bank will move gradually back from the emergency low level of rates established during the global downturn towards something more normal. And gradual means, in the view of the markets, raising rates by a quarter every three months. The MPC hiked in November, and in February, each time coinciding the move with its quarterly inflation report. On that basis, rates should rise not this week but in May.

A couple of things have, however, entered the equation. One is that recent data on personal debt and house prices have been strong. Figures last week showed that net lending to households rose by 10.7 billion in February. Against expectations of a lending slowdown, this was the biggest increase since October — before interest rates started rising. Mortgage lending is up by 14.5% on a year ago, while other consumer credit is rising by 12.5%.

Not only that, but the housing market, like some Hammer-horror Dracula, refuses to lie down. Figures from Nationwide show that prices rose by 1.4% in March, after a 3.1% increase in February. On an annual basis, prices are rising by just under 17%. Halifax said prices rose 2.2% in March and are 18.5% up on a year earlier. Mortgage-equity withdrawal — people taking cash out of housing for other uses — is running at record levels, 16.2 billion in the final quarter of last year, and 53 billion for 2003 as a whole.

For one MPC member in particular, all this is worrying. Sir Andrew Large, one of the Bank’s deputy governors, is kept awake at night by consumer debt and housing. “Each month when we on the MPC make our policy decision I am conscious of the debt situation,” he said in a speech a few days ago.

Large is the Bank’s debt hawk. The bigger the build-up, he said, the greater the risk of a nasty accident later. People will borrow and borrow, without realising quite what they are getting into, leaving themselves vulnerable to even a small interest-rate rise. “This explains why on several occasions over recent months I have found myself voting for a rise,” he added.

If nothing else is certain, it is that he will be voting to raise the base rate this week.

It is important to realise, however, where he is coming from. He is a former financial regulator, head of the old Securities and Investment Board. At the Bank he is the deputy governor with responsibility for financial stability. One of the quirks of independence is that, although the Bank’s responsibilities for overseeing the banking sector were transferred to the Financial Services Authority, it is still supposed to keep an eye on stability.

That does not mean the Large approach to setting interest rates is wrong. It does mean it will pay particular regard to the risks, perhaps at the expense of the broader economic picture. Strong debt figures and rising house prices jangle his nerves.

But it would be a mistake for the rest of the MPC to follow his lead, for three reasons. The first is that a move this week would signal that gradualism had given way, if not to panic, then to undue haste. One side-effect could be to push sterling higher, contributing further to the economy’s imbalances.

The second is that the Bank’s careful process of educating market and public opinion on what makes it move — its “reaction function” — would be cast to the winds. The headlines would say that the Bank had been spooked into a rise by booming debt and house prices.

More than that, the Bank could end up chasing its own tail. If success was measured by a slowdown in household borrowing and house prices, success could take a long time to achieve, forcing the MPC to ratchet rates to levels higher than are necessary. The housing market, in particular, might respond only when the rest of the economy had slowed.

For these reasons, the MPC’s best course of action is clear. It should have a vigorous debate this week on all the things that have set the alarm bells ringing. And then, at noon on Thursday, it should press the snooze button. Until next month.

PS: China may grab the headlines but India — regarded by many as a brighter long-term prospect — is also doing spectacularly well. Gross domestic product in the October to December quarter of 2003 was 10.4% up on a year earlier, against 8.4% in the previous quarter and 5.7% in the one before that.

Growth in the latest quarter was boosted by agriculture responding to the best monsoons for a decade, a reminder that India is still a developing country. Nevertheless, growth in the 2003-4 fiscal year is heading for more than 8%, double that of 2002-3.

It comes ahead of India’s elections, which begin on April 20. Jaswant Singh, finance minister in the ruling BJP government, has promised annual growth in double figures, supported by economic reform, if his party is re-elected.

Mention of India allows me to offer a statistical nugget. It was always said that our National Health Service, which employs almost 1.3m people, had the world’s third-biggest workforce, after the Soviet army and Indian Railways. The Russian army is now down to 1.1m but has been replaced in numbers by China’s People’s Liberation Army, with 2.3m troops, to be shrunk to 1.85m over five years.

As for Indian Railways, the plan is to reduce its 1.54m workforce to 1.2m by 2010. That will leave the NHS, still expanding, as the world’s second-biggest employer. Only the Chinese army to take on...

From The Sunday Times, April 4 2004



Comments

Do you think the last bit of information on the largest workforces partly show the emphasis of the respective governments? i.e. England - Welfare State, China - Defense

Posted by: Andrew at April 4, 2004 03:59 PM
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