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Oh dear, the economy is interesting again

The fact the monthly meetings of the Monetary Policy Committee are usually boring is a tribute to the system used to set interest rates since 1997. Many Conservatives envied Gordon Brown’s panache when, within days of Labour’s coming to office, he gave independence to the Bank of England to set the interest rates to meet his inflation targets.

Tory chancellors Norman Lamont and Kenneth Clarke had wanted to set the bank free but Prime Minister John Major would not yield political control over interest rates. The markets concluded that the timing of rate changes was being determined by political factors. They were right. Brown’s initiative brought him enormous early kudos. Inflation has been a non-subject for much of the past eight years.

But those of us snoozing awoke with a start when the minutes of the MPC’s August 2005 meeting were published. The decision to cut rates by 0.25% to 4.5%, though widely expected, had been secured only on a five-four vote. For the first time the governor of the Bank was among those outvoted. Since he votes last, he had chosen to align himself publicly with the minority. Commentators who had thought a series of rate cuts was in prospect immediately revised their view (though Roger Bootle of Deloitte’s still expects the economy to be bad enough to take rates down to 3.5% next year).

Strong language greeted the minutes. Economist Tim Congdon called the bank incompetent. He perceives an important inflationary threat from higher oil prices. “If you cared about money you could not remotely have cut interest rates last time,” he fumed.

That was especially stinging since the Bank’s chief economist Charlie Bean had deserted other bank professionals to join the cutters. No less pointedly, James Carrick of ABN AMRO commented: “If only the committee wasn’t hand picked by Brown and packed with flimsy business lobbyists, academics, journalists and ex-civil servants, we’d have got the call right.”

The row brought the composition of the committee into dispute. Indeed, it seems the governor was happy to set that controversy rolling by making it so clear where he stands.

The prospect of further rate cuts in the short term has gone out of the window. Oil prices rose 11 per barrel between the end of 2001 and February 2005. By August they had risen another 11. Those movements have not produced effects comparable with the oil shocks of the 1970s and 1980s but to assume they will have no significant impact on prices (upward) and growth (downward) would be foolhardy. Inflation will soon hit 2.5% – well above the chancellor’s target.

The Bank has also strayed into conflict with Brown in that it forecasts growth in 2005 of just 2% in contrast with his 3% to 3.5%. The chancellor is close to the edge of his self-imposed fiscal rules and will be in trouble if tax receipts are down. The bank has teased him for redefining the economic cycle, making it easier for him to pass his own tests.

Rarely has economic data appeared more confusing. One reason for caution given by the committee minority is that talk of a slowdown may have been overdone, and despite the Bank’s short-term pessimism on growth it predicts this will accelerate to 2.7% and 3.3% in 2006 and 2007.

Others cannot see where that turnaround will come from. Manufacturing, retail sales, household incomes and the housing market are all in the doldrums. We may face a prolonged period of economic slowdown and a weak housing market. In that case Bootle might well be right to predict a fall in interest rates. They have peaked and bottomed lower in each successive cycle, suggesting that next time they could go below 3.5%. But another group fears we could get sluggish growth and continued inflationary pressure, meaning we would have to sweat it out without a boost from interest rate cuts. All those calculations are made even before we factor in expected increases in taxation.

For the first time in a long time the economy is interesting and, as in the Chinese curse, interesting times are not usually good ones.

Just as the Bank of England has signalled that rates are on hold, so too has the European Central Bank which has not budged from 2% in 27 months. It is interesting that in a steady state, our interest rates are double Europe’s.

Some will see that as an argument for joining the euro. I see it the other way round. We may have uncertain economic prospects today but while controlling our monetary policy we have enjoyed 13 years of continuous growth. In contrast Germany has struggled economically, operating under the ECB’s single interest rate for the eurozone which has been inappropriate for the German economy. There, but for fortune, might have gone Britain.


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