Sunday, May 08, 2005
It was the Bank wot won it - now the hard part
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

As I was watching the results come in on Thursday night, a thought struck me. If elections are usually won on the economy, and it is my firm belief that they are, does it require the Bank of England to mess things up for Labour to lose?

Before people write in, I am aware there are instances when the economic theory of elections does not hold. Kenneth Clarke delivered an economy in 1997 that was growing rapidly, with taxes coming down and interest rates low. But voters were keen to punish the Tories for earlier misdemeanours.

In 1970, Roy Jenkins thought as chancellor he had delivered the economic goods for Labour. That time it may have been the humiliating sterling devaluation of 1967 that did for the ruling party.

What struck me during the run-up to Thursday’s election, however, was how important Bank independence was for Labour. Despite its battering on most issues, Labour won, albeit with a reduced majority. But even those who attacked the government’s record in general, and Gordon Brown’s in particular, had to concede that handing over monetary policy to the central bank was a masterstroke. Labour is now firmly associated with economic stability, and as long as the Bank delivers that stability the party will be hard to beat.

The Bank, after all, is responsible for the most powerful weapon of short-term economic control, interest rates. Its alacrity in cutting rates in response to various crises, from Asia, Russia and hedge funds in 1998, to September 11 and Iraq war jitters, has been crucial.

Without it the economy would have sputtered to a halt long before racking up a record run of growth (51 quarters and counting). The Old Lady of Threadneedle Street is not given to boasting but could emblazon the cover of this week’s inflation report with the immortal words: “It was the Bank wot won it.”

Mervyn King, as governor, warned homebuyers last June that house prices could go down as well as up and that, as much as the monetary policy committee’s rate hikes, appears to have cooled things down. Even the rate hikes were out of the way by August, before people’s thoughts had turned to the election. I am not suggesting there was anything political in this.

The Treasury, while pleased with the Bank’s record, is keen not to be left out. Its officials stress the contribution of fiscal policy, and the chancellor’s rules, to the economy’s stability. Perhaps, but the government has taken greater risks with those rules than the monetary policy committee has — proof that you should never trust these things to politicians.

Where does the Bank go from here? A few months ago a strong view was developing in the financial markets that interest rates would be coming down in response to slower growth in the economy.

Some of that was built on a gloomier view of the housing market than mine but, as far as the broad outlook for the economy was concerned, it was right. The CBI’s distributive trades survey last week made particularly grim reading, recording the biggest year-on-year drop since the economy was emerging from the last recession, in July 1992. This is not a great time to be selling furniture and carpets.

The Bank has been keen in recent months to demonstrate that consumer spending has decoupled from the housing market, and that a drop in prices would not hit retail sales much. The housing market, if anything, has been stronger than it expected, but sales have been much weaker. I think this tells us that the linkages are powerful.

Housing affects some spending directly, such as carpets and furniture. But it affects a lot more indirectly. Mortgage equity withdrawal — the amount people are taking out of the housing market, usually when moving or remortgaging — has more than halved in the past year.

Consumer spending is not the only weak spot. MG Rover and Marconi — the latter in the kind of high-technology area that is supposed to be our industrial future — have provided timely reminders that things are tough for firms that actually make things.

But this is not just a British phenomenon, as the latest purchasing managers’ surveys make clear. Industry is struggling in America and euroland, as well as here. The global economy has entered a soft patch, because of higher oil prices and interest-rate rises, including another quarter-point hike from the Federal Reserve last week. It may last for a while yet, hence the jitters in equity markets.

What should the Bank do? Talk of spring rate cuts evaporated with the Bank’s February inflation report and the emergence of a minority vote in favour of higher rates. The March rise in consumer price inflation to 1.9%, the latest in a series of higher-than-expected numbers, closed the door on such talk. knocked remaining early-rate-cut hopes on the head.

This weekend, the MPC is ruminating over its next move. Its meeting started on Friday and will conclude at noon tomorrow. So I don’t have the normal four days’ grace between this column appearing and the decision being made.

A rise in rates, which until recently looked a serious possibility, is now highly unlikely, thanks to those weak retail and industrial figures. But the Bank’s May inflation report, which we will also get this week, is again likely to predict that inflation will rise above the 2% target over the next two years. That combination, a mild dose of “stagflation”, is not a comfortable one.

This is a time, however, to treat the forecast with some scepticism. The “downside risks” on consumer spending that some MPC members have been worried about are crystallising. A hike in rates would run the risk of tipping already cautious consumers over the edge. And there is not a lot of growth impetus coming from the world economy.

So the outcome this week should be no change in rates but with the inflation report signalling a so-called “tightening bias” — in other words rates may rise at some stage.

My long-held view is that base rate will stay at 4.75% for most of this year and that the next move will be down. Let’s hope this is not proved wrong tomorrow.

PS: I haven’t yet seen any figures on how stock-market investors voted, but I suspect it wasn’t with any great enthusiasm for Labour. This government’s first term wasn’t too bad — the FTSE 100 was about a third up on election day 2001 compared with its position in May 1997. Even then, however, it was nearly 15% down on its December 1999 peak.

The second term was much worse, with shares falling by a fifth. The net result was that by polling day on Thursday, their gain over the eight years since May 1997 was under 10%. Even allowing for dividends, you would have been better leaving your money in the building society.

Why so poor? According to Merrill Lynch, real profits growth in the UK corporate sector (excluding financial companies) has been just 1.3% a year since 1997 compared with a long-term average of 3%. The share of profits in gross domestic product dropped from 21.7% in 1997 to 17.6% in 2002.

Corporate Britain seems to have been hit less by the global economy, which has grown in line with its long-run average since 1997, than by rising costs, including the extra burden of taxes and regulation.

Is the outlook still gloomy? One bright spot is that profits have grown pretty well over the past couple of years and the profits share of GDP has edged back up to 18.5% (still lower than average). That might suggest a cheerier prospect for the stock market — depending, of course, on if, or when, the chancellor decides to hit businesses with new tax rises.

From The Sunday Times, May 8 2005