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UK's MPC still too complacent Samuel Brittan: Financial Times: 24/09/04 We have had a bout of bizarre short term fluctuations in sentiments about the British economy in the last few months. Not so long ago the talk was of overheating and several further increases in "policy determined interest rates". Now the talk is of economic slowdown and of interest rates nearing a near a peak. Yet the world has not changed all that much. The most one can derive from recent housing market indicators is that the domestic property market would no longer be a good pretext for an increase in interest rates at the next meeting of the Bank of England Monetary Policy Committee in early October. But they are no justification for assertions that the housing market has turned decisively downwards. Moreover, while house price reasons for an official rate increase have for the time being faded, other justifications have been gathering force. Policymakers would give a lot know whether the UK economy as a whole is overheating, in other words if it still growing too fast to maintain non-inflationary growth in the medium term. But put this way, it is almost impossible to answer. If we accept, for instance, the OECD estimate of 3.4 pc real GDP growth in 2004 this does not tell us very much without knowing the trend rate of growth - which the Treasury puts a trifle optimistically at 2¾ per cent. Even more important: we do not know the size or even the sign of the "capacity gap": that is how far the economy is above or below a normal non-inflationary level of operation. The whole point of the monetarist revolution, which the technicians seem to have forgotten, was to get away from posing these unanswerable questions about real parameters.. The London firm of Lombard Street Research has for some time been propagating a brave minority view that the Bank of England Monetary Policy Committee is "too relaxed about inflation". It puts a good deal of emphasis on broad money (M4) whose growth has accelerated to 9.7 per cent in the year to August, the fastest rate of increase for over six years. If continued for long, it is unlikely to be compatible with anything like the government's inflation targets. The growth of the credit counterpart, known as "M4 lending" accelerated to 12.2 per cent, the highest since early 1991. Lombard Street remarks: "there is plainly a rampant credit boom still under way in the UK economy". One good common sense reason for paying attention to the monetary numbers is that they are now extremely unfashionable - a sign that they may be about to matter. But Lombard Street does not base its hawkishness on monetary numbers alone. There is plenty of other evidence. Private sector pay increases have, after two years of lagging, risen above public sector ones. Despite this month's dip, the CBI's index of manufacturing orders and output are above their long run averages. Moreover its survey of domestic price expectation is now averaging higher than anything seen since 2000. My own favourite policy guides are still Nominal GDP and real interest rates. There has long been a consensus view that the trend of Nominal GDP in most advanced industrial countries should be around 5 per cent per annum, leaving room for 2-3 per cent real growth and a similar amount of modest inflation. UK Nominal GDP has been creeping above this rate. Its rise this year has been estimated at 5¾ per cent by Goldman Sachs and is expected by the Treasury to rise next year to around 6 per cent. Not catastrophically high, but above rather than below what is consistent with non-inflationary growth. The real rate of interest is tricky to estimate because the government has bemused us with so many different inflation indicators. The most fundamental is one which is not targeted, namely the GDP deflator, which appears every quarter with a lag. But on latest indications it has been running at some 2¼ per cent compared with a policy determined interest rate of 4¾ per cent. This would give a real short term, interest rate of 2½ per cent, above prevailing international levels, but below its likely long run equilibrium level of at least 3pc. For a long time the main justification for caution about raising British interest rates was the high pond. But for a number years the UK economy has been flourishing against a level of sterling which many forecasters would have regarded as unsustainably high. In any case the trade weighted sterling index has now fallen by 3 per cent below this year's peak and is now also well below the levels typical of the early years of this century. Nor is the international conjuncture a valid reason for erring on the side of cheap money. The OECD has actually raised its combined forecast for the main industrial countries for this year from 3.4 per cent real growth to 3.6 per cent. Private sector analysts tend to be more pessimistic, mainly I suspect because they give more weight to the US for which the OECD has indeed reduced its estimates. As usual, I look at the balance of risks. Suppose that the MPC does round up the policy determined short term interest rate from 4¾ to 5 per cent and this proves too high. It can easily be reversed at the bearable cost of egg on someone's face. But suppose that it stays its hand and the hawks prove right. The risk then is of a sudden change of view and a sharp increase in interest rates which really will trigger just that housing collapse which the doves fear so much. But of two things I feel reasonably confident. One is that the movement of the international oil price - about which it is also fashionable to be complacent - will matter far more even in the UK than the exact timetable of MPC decisions . The other is that is that there is little to be gained by the British chancellor wagging his finger at European countries for not growing faster simply because their failure to do so makes his own domestic problems a bit more difficult.
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