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Dear Eddie,
In our last letter we sympathised with the Monetary Policy Committee, not so much for the difficulty of the choice they had to make, for what needed to be done was obvious and underlined by our recommendation of a further interest rate reduction. Our sympathy was for the confused indicators on which they had to judge and this month’s indicators are even more difficult to interpret.
We expect they will incline the committee to play safe with a holding decision for no change. In our view when the waters eddy and the winds change, rather than drifting, the sensible course is to switch on the engine, steer the boat out of the doldrums and give a boost to growth by reducing interest rates and giving a growth signal to markets rather than playing Banking Mickawberism. The confused signals are:
(1) Where is the economy heading? You are trying to treat two economies, that of production, investment and exports and that of services and finance with one medicine, though each suffers from a different disease. Which is basic?
(2) Is the growing trade deficit going to become an ever tighter restraint on growth, a threat to sterling requiring us to finance the growing flow of imports which we cannot pay for with our stagnating exports? The answer to these questions depends on whether you look at the deficit as expressed in actual current prices, where according to Tim Congden of Lombard Street Research, it is a manageable 2.2% of GDP or in constant price figures going back in real terms to 1995 which indicate a 7.2% deficit, on a scale similar to that which is already threatening the dollar.
(3) Are house prices about to peak and possibly go into reverse, or will the bubble go on inflating as mortgage lenders seem to fear when they issue their unprecedented call for an increase in interest rates?
(4) Is the rise of the euro against the dollar and the recent fall in the pound the beginning of a sustained trend and an indication, as advocates of euro entry have claimed with a touch of desperation, of the opening of the door to membership? Or are they comparatively minor shifts which will be corrected if the American economy picks up and the flow of money into the US resumes, taking the dollar back up and probably us with it?
None of these ambiguities and contradictions point to any rise in inflation. That remains lower than in other economies which have lower interest rates, real and nominal, than us. Nor does any of it point to higher interest rates. Even the house price rise which is usually sensationalised by the more vapid financial commentators (a considerable number) is largely a south eastern phenomenon which has no necessary connection with inflation, now or to come. It certainly does not figure in the published measures by which the Bank`s course is set and is, in any case, counteracted by the fall in the stock market with consequential effects on pensions and expectations.
In this situation the real economy of unemployment and production should be at the centre of your pre-occupations. That is stagnating. Growth will be substantially lower, even than the modest predictions on which the Chancellor based his spending plans. It needs a boost. That can come only from lower interest rates boosting demand, encouraging investment, and giving a signal to markets that government and the Bank want a more competitive exchange rate to encourage exports and help the trade balance.
The narrower trade gap on the Lombard Street current price figures occurs because the price of services exported has risen, while the price of manufactured imports has fallen. That improvement should go on but is no compensation for the decline of manufactured exports. These are still the majority of our export's. As world prices fall they face increasing competition which they can only challenge with a more competitive exchange rate. We want a substantially lower exchange rate. A fall is beginning. Any increase in interest rates will check it and give a signal that it will be resisted where we should encourage it and can do so without inflationary repercussions.
Inflation, the lodestar by which you steer, is no longer a problem. What indications are there in any but the house price figures that it is likely to rise? We see little value in pointing to fears of inflation ahead when the Bank`s own inflationary predictions have not materialised and the MPC itself has always taken too bearish a view by managing for inflation lower than the target figure and never erring on the side of growth.
The Bank`s record on interest rate since it took sole control and sallied out with neither caddy nor captain in its game of one club golfing has, in fact, been constantly more deflationary than it should have been. Rates have for much of the period been higher than either America`s or the European Central Bank but there is no reason for this. Nominal rates are lower than for decades and much has been made of this. Yet in fact real rates are quite high compared to periods of higher inflation. Inflation has consistently undershot, meaning that the economy had more room for growth than the Bank has allowed. So instead of seizing the great opportunity to expand and grow which offers with the disappearance of the inflationary threat, policy has damped down the growth which was there rather than boosting and encouraging it. It has pushed manufacturing into the third major wind down experienced since the Seventies. Manufacturing has suffered for the same reason as produced the earlier two in the early Eighties and the early Nineties - because sterling has been consistently too high. It remains so ensuring that we will not benefit from European or world recovery as it comes but will face a growing surge of imports from them. We are particularly surprised at the assertion in your last bulletin that "output is close to potential". It is, in fact, nowhere near and given an economic boost output can be enormously expanded quite quickly in several areas and underused resources brought back into production . You should examine your figures on this and ease your fears. Most of manufacturing is under-run.
Managing in this fashion must mean that the Bank is afraid of growth and fearful that it and the fall in the exchange rate which goes with it must have serious inflationary repercussions, taking the inflation rate to levels outside the Bank`s target range. You can`t run a healthy economy on fear, particularly when it isn`t justified by the facts. The assumption has never been explained or justified and runs contrary to the practical experience of the American economy where the dollar came down by 40% from its 1985 highs and Britain`s own experience after the collapse of the ERM when the pound came down, interest rates came down, growth went up, and the economy came as near to prosperity as it has since the Sixties, all without inflationary consequences. Inflation remained low and stable despite all the dire predictions and the conventional quaking at every wage settlement, skill shortage, credit explosion or public spending surge which is still going on.
The Bank has consistently erred on the side of caution and leaned against growth in the good years. Now that that good period is coming to an end the economy stagnating and real difficulties lying ahead it is important that caution should not be compounded by fear but rather that the Bank should learn the lessons of its first five years and accept that its essential and basic responsibility is to boost the real economy by lower rates with the benefits they bring to demand and investment and by encouraging the fall in the pound which has begun but which needs to be boosted by management and clear signals from the Bank. Only that can make the fall substantial enough to encourage those sections of manufacturing which are flagging or on the point of giving up the unequal struggle.
We need to boost production which has collapsed and investment which is pathetic. The aim of economic management should be to provide the opportunity of growth and buoyancy which alone can really encourage the new and boost existing production, for only a growing economy can bring in underused resources back into production. Cheap money boosts output bringing lower unit costs, increasing the tax take and diminishing the social spend by putting more people back to work. This is the long term antidote to inflation. It is now more than time to stop fearing hypothetical inflationary threats and palsying action by excessive caution and get on with economic growth. We, therefore, recommend a reduction of interest rates and an end to the dithering signals that they might rise, they might not. |
