Sunday, August 31, 2008
Bank needs to slip off its inflation shackles
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


There is no doubt that many sectors of the economy could do with the tonic of an interest-rate cut. Housebuilders, anxiously awaiting Gordon Brown's autumn rescue package (and probably prepared for disappointment), would love it.

So would Alistair "austerity" Darling - apparently reconciled to the biggest downturn in the postwar period - though I would be surprised to see that reflected in next month's Treasury forecasts.

A cut in rates would also be welcomed by retailers, manufacturers and just about every business except corporate undertakers. But how could the Bank of England's monetary policy committee (MPC) justify it? Growth may have halted but inflation has yet to peak.

Sterling, caught between seismic shifts in the dollar-euro exchange rate, looks shaky. Last week its average value dropped to a 12-year low, and the $2 pound is becoming a fading memory, with the rate down in the low $1.80s. Would not lower interest rates condemn sterling to oblivion?

In fact, finding an excuse to cut rates may not be as hard as it looks. Even sterling does not present an insurmountable obstacle. A large part of the reason for its fall, as noted, has nothing to do with Britain.

The part that does is mainly related to gloom about UK growth prospects and the perception that the Bank of England is constrained by high inflation from doing anything about it. If the Bank could demonstrate that it is free of such constraints, sterling could even benefit. It may be much too soon for some but the dollar's rise has something to do with the perception that the worst may be over for America.

One MPC member, David "Danny" Blanchflower, has no difficulty over cutting rates, stressing the extreme downside risks to Britain's economy and the urgent need for the Bank to do something about it. Last week he attacked fellow committee members for their "misguided" worries about heightened inflation expectations and said the Bank's prediction of a broadly flat economy over the next 12 months was "wishful thinking". Output would fall, he said, and inflation "plummet like a rock".

Other members, however, are a bit more squeamish. For them, the criticism they have faced as a result of presiding over inflation more than double the target is bad enough, without adding fuel to the fire by reducing rates ahead of firm evidence that inflation is subsiding.

Fortunately, there may be a way of getting there sooner. Geoff Dicks, an economist with Royal Bank of Scotland, notes that Bank governor Mervyn King and colleagues have been emphasising what is known as "money" GDP. This is just gross domestic product, or national income, in cash, as opposed to "real" GDP, which measures inflation-adjusted growth.

Money GDP featured in June, when King wrote to Alistair Darling, the chancellor, to explain why inflation had risen above 3%. "In contrast to past episodes of rising inflation, money spending is increasing at a normal rate," he said. Its rise in the year to the first quarter was 5.5%, "in line with the average rate of increase since 1997 - a period in which inflation has been low and stable".

The Bank returned to money GDP in its inflation report this month, making the same point about its growth being in line with the post-1997 average, but also noting that the way monetary policy affects inflation is through its influence on money or "nominal" demand. The weaker the growth of money GDP, in other words, the more the downward pressure on inflation.

The reason this is interesting now is that money GDP has taken a sharp downward lurch. Figures released a few days ago showed its growth rate in the second quarter had slumped to 4%, considerably weaker than its recent average. It may be telling us, more reliably than any forecast, that inflation worries are misplaced and the Bank could safely cut interest rates.

Those who have followed the monetary policy debate over the years will know money GDP has an honourable place in it. After the Tory government got into difficulty with money-supply targets, there was a campaign, led mainly by Samuel Brittan of the Financial Times, to use money GDP instead of those troublesome targets.

Pressure to switch to a money GDP target persisted, but went out of fashion after 1992 when the government successfully adopted an inflation target. I am not advocating a change in target, though money GDP, which combines inflation and growth, is worth looking at more closely.

So what of this week's rate decision? The "shadow" MPC, which meets under the auspices of the Institute of Economic Affairs, has given its verdict. Two of its members favour immediate action. Both Patrick Minford and Peter Warburton think there should be a half-point cut.

Minford castigates the Bank for implying it is powerless in the face of recession and warns that politicians may conclude it is not "fit and proper" to run monetary policy. Warburton said current inflation was "spilt milk". He wants a 1 to 1.5 percentage-point rate cut over three months.

Other shadow MPC members are less aggressive but five have a "bias to ease". Tim Congdon, Gordon Pepper, Andrew Lilico, Ruth Lea and John Greenwood all believe the Bank should be thinking about lower rates, if not immediately. Pepper thinks the bias should be towards cutting rates "sharply", while Lea would cut by half a point if the data continue to worsen.

This leaves only Trevor Williams of Lloyds TSB and my near-namesake David B Smith who think the next move should be up. The kind of debate on the actual MPC is similar, though probably less colourful than on its shadow.

The Bank's own forecasts imply "money" GDP will slow further as annual growth slows towards zero and inflation gets over its autumn hump. This week's MPC meeting is regarded in the City as a done deal, with no change expected.

October, however, could be interesting. Not only should the path of inflation be clearer but on September 30 there will be a full, extensively revised, set of GDP statistics. The argument for delaying rate cuts could be looking very thin indeed.

PS: How, in hard times, is the skip index? Pretty good; the count in my street stands at two, suggesting normal growth, though I warn again about the "staying put" distortion - people who would have moved deciding to improve.

Let me tell you of a new hobby - spotting "credit crunch" in the oddest headlines. It was sparked off by one: "The royal recession: Queen hit by credit crunch", a story with everything but a new twist to the Diana conspiracy.

Here is a selection from this month, starting with the straightforward: "Buskers are hit by credit crunch", "Camp sites booming in the face of credit crunch" and "Less food being wasted thanks to credit crunch". Then there is the women's angle: "Our credit crunch wedding cost 597".

There was a column: "We've become a nation of credit crunch cry babies". What about "Medieval living defies credit crunch" or "Credit crunch bitten by tooth fairy"? But for sheer optimism, salute the Daily Express: "Credit crunch will boost house prices". Others gratefully received. I'll offer a crunch-related book as a prize for the most bizarre.

From The Sunday Times, August 31 2008