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Dear Eddie
Like many people and the economic commentators we ourselves esteem, we were both surprised and concerned by the MPC’s paradoxical decision to raise interest rates last month. The reasons given for it just do not stand up. If house price rises are such a problem a mini-rise in rates has no effect at all while the ritual claim that a small increase now checks inflation and prevents a bigger one later is questionable when inflation is so low.
What the decision does do is give exactly the wrong signal to markets and cast a rather dubious light on the MPC’s priorities and judgments. It indicates that house prices in the South East, even though they are not part of your remit, are more important to you than the needs of manufacturing in the North and the Midlands, despite past protestations of sympathy. It indicates a lack of real concern about the gross overvaluation of Sterling since it was all too easily foreseeable that any signal on British interest rates will have a disproportionate effect on Sterling when German recovery is still not certain and anxieties cluster around the long term prospects of the US where anxieties about the sustainability of present stock market highs are becoming chronic. The fact that Sterling is now over 3DM is very worrying. There is no indication of what is to bring it down now that the Bank has given this signal to markets.
The only consolation is the demonstration that the Bank is prepared to change interest rates for macro economic reasons which have nothing to do with its binding requirement on inflation. That requirement now suggests that rates should come down. Yet you put them up. So we are consoled by the thought that if your committee can be convinced that other macro requirements apply, as they do, you will be prepared to act on them too.
Therefore, we come to our advice which is to reduce interest rates to Euro-land levels. We suggest this for the following reasons :-
- The paramount need to end the overvaluation of Sterling which we estimate at 25-30%, the IOD at 15% and a whole range of authorities at something between these levels. Only a clear signal on, and a substantial reduction of, interest rates can do this.
- The opportunity to do this and to get a higher growth rate are both there. Inflation is low and there is no indication from either American experience or ours after 1992 that an increase in growth and a fall in unemployment lead to inflation.
- This is a historic opportunity to grow which we should seize now. There is a balance of risks between inflation and stagnation and the choice at the moment has been too far to the stagnation end of the risk spectre. The Pound will eventually fall if it’s not brought down. You now have the luxury of managing it down. If it falls because of the deteriorating balance of payments or because of the unhealthy economic situation overvaluation leads to or because the Dollar slides you will be under considerable pressure from an uninformed clamour of misguided opinion to increase interest rates and shore it up. Action now avoids worse later in this area at least.
- We are in a single market with economies enjoying interest rates half ours and more competitive exchange rate against us which results. To maintain those differentials for any sustained period will be deeply damaging.
- The economy is substantially under-performing. Running it at these levels is economically inefficient and increases costs. Growth cuts them.
- Decisions taken now will have their consequences between one and two years on. The most likely date for the next election is May 2001 and governments like rosy scenarios. We are not, of course, suggesting that this should be any influence on your decisions but the effect of those decisions on the state of the economy in 2001 will have a major bearing on judgments on the success or failure of the MPC experiment.
- We underline the analysis by Professor Tim Congden, a monetarist whose views we respect, which indicates that core inflation will fall to 1.5% by end 1999, 1.2% in March 2001. To justify present interest rates and negate our demand for a reduction it is essential to refute this prediction. Can you? You have increased rates on the basis of fears and claims that the economy will behave now, as it did in the past, at times of high inflation. This is not realistic now, a time of low inflation. Look at reality and all the pressures keeping inflation permanently low. Ignore the Seventies and Eighties and the unrealistic fears that very different experience gives rise to.
- After two years of marginal shifts while the MPC finds its feet it now needs a more consistent strategy and a coherent approach which markets can understand. In present circumstances that can only be a growth scenario achieved by cheaper money and a more competitive exchange rate.
We hope that your Committee will give serious consideration to these views and make an attempt to understand where it went wrong last month.
We have set out our views of how the economy functions in the pamphlet we sent to all MPC members last week. We hope that you will read, learn and thoroughly digest. We hope, too, that you will give us your reactions because these issues and the bases of judgments on both sides need to be set out and thoroughly discussed, not reduced to unjustified ex cathedra statements on one side and pundit babble on all others. The Fed now makes clear statements on both its policy and the direction of its future policy. Why not here? |
