Sunday, June 27, 2004
Bank scuppers the electoral cycle
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

For the past seven years relations between the Treasury and Bank of England have been almost cloyingly cordial. The chancellor has supported the governor in everything the monetary policy committee (MPC) has done. Threadneedle Street, meanwhile, has kept its side of the bargain.

Gordon Brown has had good reason to be grateful to the MPC. It has provided the cornerstone of the economic stability of which he is so proud. It has also, from a political perspective, been remarkably well-behaved. While there was nothing political about it, events conspired to ensure that interest rates were falling before the last election, the first after the Bank’s independence.

The Bank has also steered clear of criticism of the public finances, a tradition Mervyn King seems determined to maintain. Last week he denied that comments in his Mansion House speech on June 16 were intended to cast doubt on the Treasury’s projections, or Brown’s prospects of meeting his fiscal rules.

Nonetheless, a little grit has entered the relationship. While the governor set the record straight on the public finances, he chose to repeat his comments of the previous week on house prices. He warned that “the chances of house prices falling are greater than they were”, and that people should heed this and the prospect of higher interest rates.

Nothing particularly controversial, you might think. Some would even say (see below) that King should perhaps have spoken out before. The Treasury has had its own worries about the housing market — hence the Barker and Miles reviews of housing supply and the mortgage market.

From a political perspective, however, the governor’s message could hardly be less welcome. According to the market consensus, the only way for interest rates to go is up. The next rise will come in August, followed by increases in November, February and May next year. That would take rates to 5.5% or thereabouts by the likely time of the general election, May-June 2005.

Not only would the memory of 3.5% rates in 2003 have faded, but homeowners and businesses would have endured the biggest rise in the cost of borrowing in percentage points (two) since the Tory boom and bust of the late 1980s and early 1990s. More strikingly, monthly interest payments for any borrower experiencing the full impact of this would rise by nearly 60%.

I have written before that we should get out of the habit of automatically regarding interest-rate rises as bad news. Much of what we are seeing is a return from an “emergency” low level to normal or neutral rates. The same will apply when the Federal Reserve starts raising rates in America from 1% this week.

Even so, a prolonged rise in rates in the run-up to an election is unusual. According to my researches,the last time it occurred was in February 1974, when Sir Edward Heath’s Tories lost to Harold Wilson’s Labour. Before Bank independence, no chancellor worth his salt would go into an election with rates on the rise.

The benefits of independence are huge. The political disadvantage is that there is no longer any guarantee that the electoral and interest-rate cycles will coincide.

That is not all. If the governor’s warning on house prices comes to pass, the criticisms of Brown’s period in office — that it was all built on the shaky foundations of rising debt and an unsustainable housing boom — will come into play. Such criticisms are, I think, unfair, but so is politics.

According to Capital Economics, a forecaster in the housing “crash” school, the rug could be pulled from under the market at a time of maximum inconvenience for the government. It predicts that prices will start falling significantly on a month-on-month basis in December, and that by election time, will be dropping on a year-on-year basis.

Even if the housing market does not go into reverse, a rapid cooling is in prospect and this will change the consumer mood. Some say it is already happening. Christopher Smallwood, Barclays’ chief economic adviser, believes that consumer spending will slow from growth of 4% this year to just over 3% next as the housing impetus diminishes. The harder the housing market lands, the bigger will be the effect.

Rising interest rates and a cooling housing market will surely reduce “mortgage equity withdrawal” — people taking out some capital gains when remortgaging or moving house. Official figures show this to be running at an annual rate of more than £64 billion at the latest count.

What all this means is that, as far as consumers and the “feelgood factor” are concerned, this year looks better than next. The economy, it seems, will be beyond this year’s “sweet spot”. From Tony Blair’s perspective, the longer the election is delayed the more the situation in Iraq should get better, and improvements in public services show through. From the chancellor’s viewpoint it looks like a case of the earlier the better.

Brown still has plenty of aces up his sleeve. The comprehensive spending review, which was due this week but is now a couple of weeks away, will be marketed as “prudence for a purpose” — plenty more money for priority services, combined with efficiency savings.

He will have one more budget before the election, in March next year, which will be populist in tone if not in the size of any giveaway. But then again, another budget will resurrect all the old questions about the public finances and “Labour’s third-term tax rises”.

This, then, is an interesting moment. The government is not yet in any serious trouble over the economy. How could it be after 12 years of uninterrupted economic growth and with unemployment so low? But the potential for difficulty is there, and so is Brown’s agitation.

PS: Last week’s column setting out comparisons — and some contrasts – between the housing markets here and in Australia has drawn a lot of comment, as well as some new information.

One contrast is that the central bank, the Reserve Bank of Australia (RBA), has been a lot more active in warning of the dangers of a house-price bubble. The RBA’s warnings, which go back two years, contrast with the “purist” approach of the Bank of England, which until Mervyn King’s recent warnings has steered clear of so-called verbal intervention in the market.

This has been a long-standing dilemma for the MPC. Sushil Wadhwani, in his final speech as a member, queried whether there should be circumstances in which the Bank abandons strict adherence to the inflation target to try and puncture an asset price bubble.

The RBA appears to have done just that. At the same time, as Peter Williams of the Council for Mortgage Lenders points out, the central bank has been more explicit in arguing for a significant rise in the “fair value” of housing in relation to earnings, in the light of low inflation and interest rates.

There are other differences. Australia’s housing boom, even more than here, was boosted strongly by buy-to-let investors, helped by tax incentives. Many such investors, however, appear to have decided that now is a good time to get out. In New South Wales a new “exit tax” on investment property was introduced in the April budget, taxing some of the capital gains and further deterring investors.

Have I, taking in the experience Down Under and King’s warning, joined the housing bears? No. I do not expect a “crash” with, say, prices this time next year significantly lower than now.

But, while the signs are tentative, we appear to be entering a stagnant phase for the market. That will mean some month-on-month price falls. It should also mean that the bubble gradually deflates.

From The Sunday Times, June 27 2004

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