Sunday, February 05, 2006
Pendulum still swinging on interest rate cuts
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

When the Bank of England was given its freedom in 1997, after 300 years of being fettered by the Treasury, there was an unspoken assumption that independence would take both the politics and the debate out of setting interest rates.

Ask nine doctors for a diagnosis and as a patient you would be alarmed if they came to wildly opposing verdicts. Take your car to the garage and you would worry if one mechanic said the engine needed fixing, while another blamed the gearbox.

We have learnt monetary policy is not like that. Policymakers take the same information and come to different conclusions. That isn’t just because of the joke that if you put nine economists in a room you will get 10 different opinions. It is because setting rates is not just a technical exercise. It is about judgment; and judgments vary.

Right now there is an interesting clash of judgments emerging on the MPC. Professor Steve Nickell, one of the four external members, has voted for two months to cut rates from the current 4.5% level. None of the others have joined him. He has been a lone dove.

In a speech last week he explained the reasons for voting to reduce rates and also provided an excellent explanation of how the MPC works, which students of UK monetary policy would do well to read; available on

It is a common view that, since the Bank has an inflation target, it should not concern itself with growth. Mervyn King, the governor, may have accidentally given succour to this when he said last year there were limits to what the MPC could do. “Monetary policy cannot ensure that output will grow at a constant rate,” he said last autumn in Newcastle.

Lord Lawson of Blaby, the former chancellor - who perhaps should know better - warned the Bank last year that “few things could do more harm to inflationary expectations than a feeling that you did not have your eye very firmly on one ball and that maybe your attention had wandered equally been activity and inflation”.

But, as Nickell patiently explained in his speech, the Bank has to take a view on growth to form a judgment on inflation.

“The factor driving changes in inflation over the longer term is the level of demand in the economy relative to the potential supply,” he said. “If the former exceeds the latter, then we may expect inflation to be rising, and vice versa.

“It is plain that if you are trying to hit an inflation target, you have to form a judgment about the level of demand in the economy relative to potential supply ... This must, among other things, involve making judgments about growth prospects, not for their own sake but because they are vital when it coes to understanding the prospects for inflation.”

Of course, as he noted, the Bank cannot ignore direct influences on inflation like last year’s rise in oil prices, and has to be sure these do not result in so-called second-round effects through higher wages. MPC members are concerned about gas prices, which have yet to fully show through in inflation.

But the key relationship is between growth, the amount of spare capacity and inflation. He thinks there is some spare capacity, for which rising unemployment provides supporting evidence, and though growth in the final quarter of last year was a close-to-trend 0.6%, he doesn’t see it getting much stronger. So spare capacity will remain, and inflation - now 2% in line with the target - will fall.

Nickell appears to have some support for his view on the MPC. “You're starting from a position where to keep inflation on track in the longer term you do need to have growth picking up,” said Kate Barker, another member, in an interview with The Guardian. “There are question marks about whether the pace of growth is going to prove strong enough.”

He also has support on the “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, and which provides even more convicing proof that when there is scope for economists to disagree they will do so. Three members of the shadow MPC think there should be an immediate quarter-point cut in base rate, two want a hike of a similar amount and four are happy to leave it where it is.

The cutters, like Nickell, are concerned about growth and its likely impact on inflation. Roger Bootle believes “economic growth will continue below trend”, Professor Anne Sibert cites “signs of labour market weakening” which are consistent with subdued pay pressures, while Peter Warburton thinks the private sector is facing real interest rates that are too high. That helps explain the weakness of business investment.

What about the view that rates should be raised? The two hikers offered different reasons. Professor Gordon Pepper is concerned about asset-price inflation, and cites the current “bubble” in index-linked gilts. Professor Philip Booth worries about rapid money supply growth. Last year’s slowdown in the economy, he said, could reflect the damage wrought by the government’s tax and spending policies, and it is no business of the MPC to try to counteract such weakness.

This is the nub of it. It would be a big surprise if the Bank were to do anything this week. Housing has strengthened and retailing is off its knees but the jury is out on what will happen in the coming months. Several City firms have pencilled in a rate cut for May, while others think that is when the Bank will start hiking.

For the Nickell view to prevail, two things are needed. One is that growth does not pick up and that a more subdued consumer, alongside weak exports and investment, leaves the economy expanding at a below-trend rate. The other is that committee members will need to be confident of what the trend rate of growth is.

The Bank, and the Treasury, work on the basis that the economy’s trend, or long-run, growth rate is about 2.75% a year. It is possible, however, that this - while close to the average of recent years - flatters it. What if the economy has benefited from a series of favourable factors that are now fading? What if the true story of the economy’s growth potential is reflected - as in the end it should be - in the productivity numbers.

Productivity growth since 1997 has averaged 1.6% a year. Add half a percentage point for workforce growth (largely due to immigration) and you do not get much more than a 2% trend growth rate.

This is a big issue, of relevance not just to the next move in interest rates but to Britain’s long-term prosperity. I share, just, Nickell’s view that a small rate cut will be needed. The larger question is what will be needed to improve the economy’s long-run performance.

PS Alan Johnson, the trade and industry secretary, criticised British businesses last week for being on the “slow boat” to China; missing out on the opportunities there. That is also true of India, the other fastest-growing Asian giant.

It is fairly well known that only 1% of UK exports go to India. What’s less well known is that 40% of those exports are accounted for by diamonds and that Britain has just been overtaken by Belgium as an exporter to India. Not only that but Indian businesses invest more in Britain than vice versa.

Last week the India-UK Joint Economic and Trade Committee (Jetco) met in London. It agreed to try to boost trade and investment in infrastructure, healthcare, agroprocessing and high technology, with a particular focus on small and medium sized firms. India’s fast-growing private sector is desperate to trade with Britain.

At this point it is customary to slam British exporters for failing to capitalise on such obvious opportunities. But I don’t. If I were a medium-sized exporter I wouldn’t know where to start in the Indian market. And, to judge with my recent brief contacts with its London operation, India’s bureaucracy is a formidable barrier to trade.

From The Sunday Times, February 5 2006


Any cut in interest rates will only work by increasing the debt burden: isn't there a danger of us becoming addicted to this medicene, given China, immigration and the Internet are all structural changes limiting inflation? Is 2% CPI inflation still a realistic target, or have circumstances changed since 1997? (Historically there have been prolonged periods of lower inflation and deflation.)

In Keynesian theory the government borrowed to spend our way out of recession: now consumers are expected to take its place when their debt is already at record levels! Whose interests does this economy serve? Why should consumers get into more debt to make the prices they pay more expensive - paying interest and inflated prices? In stimulating the economy to keep it at full capacity lenders are being encourgaed to lend and others to borrow, and to hell with the risk. Repossessions are already rising...

Posted by: David Goldfinch at February 5, 2006 06:43 PM