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The Bank should act soon Samuel Brittan The Financial Times 04/03/05 The desire of the Bank of England governor to make monetary policy "boring" may have been frustrated by the emergence of a division for the first time in nine months in the Bank of England's Monetary Policy Committee. As recently as December, silly "doves" in the City were expecting interest rates to be cut. We now know that at the February meeting of the Monetary Policy Committee, one brave member from the Bank's own team, Paul Tucker, voted for an increase. The minutes hint at a greater divergence than the bald figures suggest. But I cannot help reflecting how limited is the value of the official Bank inflation forecasts. According to the MPC minutes the outlook for internal demand has improved since the last meeting but external indicators have deteriorated. The committee concluded that there was likely to be both more real growth and more inflation than it had earlier expected. But the risks were nevertheless "on the downside". So you take one move forward and one step back and you end up where you started. And of course there were "uncertainties" appearing in almost every sentence, as if we needed to be told that life is not very predictable. Behind all the verbiage is an argument about whether the UK economy is suffering from excess or deficient demand. The Treasury believes there is a deficiency; Mr Tucker clearly thinks there is an excess and the majority of the MPC are somewhere in between. The latest estimates show gross domestic product at market prices rising by about 5 per cent a year and real output rising by nearly 3 per cent. If the underlying trend of output is 2½ per cent, growth is too high. Even on the Treasury's own trend estimate of 2¾ per cent there is still some excess pressure building up - unless there is an "output gap" in the economy that can be safely filled. Unfortunately, looking for the output gap is like looking for a black cat in a dark room. Mr Tucker's reasons for favouring an increase were that growth had recovered from a soft patch in the third quarter and that the equity, credit and housing markets had been "stronger than expected". More to the point, "short term real rates would probably be reduced by gently rising inflation and broadly unchanged nominal rates". Demand pressures would be stimulated "when it was likely there was already a danger of excess demand". This had shown up already in indicators of capacity utilisation and wholesale prices, but not yet in earnings. I would put the emphasis slightly differently. Inflation pressures may well have a monetary root. In most of the post second world war period they were transmitted through the labour market, and many observers are surprised that they have not emerged with present rates of growth and employment. But the most likely pressures now come from a different direction: rising import prices, a high price of oil and the vulnerability of sterling - all subsequently mentioned by Mr Tucker. The best case I can make against an increase in interest rates is that British "policy determined" short term nominal rates are high by world standards: 4.75 per cent, compared with 2 per cent in the eurozone and 2.5 per cent in the US. The picture, however, looks rather different if we look at real interest rates. The Treasury's Pocket Databank puts real short term rates at 1.6 per cent. This is probably too low because it is deflated by the old-fashioned Retail Prices Index. On the other hand, if it is deflated by the so-called Consumer Price Index - an EU-based index that excludes housing costs altogether - we get a much higher real rate of more than 3.2 per cent. The truth probably lies somewhere between the two at about 2.4 per cent. This is still high by international standards. Most Group of Seven countries have zero or negative real interest rates. Goldman Sachs has estimated a plausible "neutral" level of short term real rates for the eurozone of about 2 per cent. This has to be higher for the UK because of the downward risk attaching to sterling. One illustration of the risk is that British long term nominal government bond yields are one percentage point higher than those of the eurozone. The world economy is being stimulated by a combination of budget deficits and cheap and easy credit, which many orthodox financial observers find disturbing but which is probably better than the alternative. Whatever the case at world level, the UK is not in need of a stimulus. If the Bank does not act next week it will find it difficult to raise rates in April, if it is to avoid the charge of undermining the government in the run-up to a May 5 election. But it will be difficult to raise them in May or June without being accused of deferring action to help Labour. No less an authority than Ed Balls, the chancellor's closest adviser, has given the green light for acting soon.
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