The old joke about government statistics being in such a fragile state that there is now more uncertainty about the past than there is about the future sums up the dilemma facing policy makers today. While much anecdotal evidence points to a booming economy, the official data suggests activity was flat in the past two quarters.
To plan any journey properly, it helps to know where you are starting from. But the Monetary Policy Committee, which is trying to plot the path of interest rates, is getting very mixed signals about exactly where we are at present. If the economy is weak, an increase in rates could undermine confidence and choke off the nascent recovery. However, to leave rates on hold when the consumer sector is showing signs of overheating, may be inviting more severe measures later in the year.
Those who believe the economy has been standing still point to subdued equity markets, weak company profits, a poor productivity record, flagging exports and a lack of investment, to support their case. Those commentators calling for a stewards’ inquiry into the GDP figures cite a steady growth in employment over the past 12 months, increases in incomes and spending, a weakening saving ratio, and buoyancy on the high street and in the housing market, as evidence of an under-reporting of activity.
Whichever way the statisticians resolve the apparent contradictions in the numbers, there is no doubting the strength of the consumer sector.
Parallels with the late 1980s are obvious, particularly in the housing market, and this is the single biggest argument in favour of higher rates.
House prices rose in May alone by 2.1% and personal debt by £7.7bn (all but £2bn of which was housing-related). With borrowing rising four-times faster than earnings, the warning signs are there.
Relative to incomes and interest rates, this debt is still affordable, and a late 1980s-style housing crash is not on the cards. But it is easy to foresee problems ahead if borrowing continues and rates rise. Consumers need to be persuaded to ease off, and a small rise sooner, rather than a big increase later, will send the appropriate signal.
While consumer spending keeps the economy moving, benefiting in particular service sectors such as retailing and leisure, manufacturing has been languishing in the longest and deepest of the four recessions it has experienced over the past decade. The appreciation of sterling since the mid-1990s, and recent slowdowns in the US, Europe and Japan, have been the principal causes of manufacturing’s difficulties. Indications from authoritative sources, such as the CBI’s Industrial Trends Survey, suggest the worst is probably over. Much of this is attributable to an improved outlook overseas, amid signs that the US and Europe are recovering.
If exports are to make a bigger contribution to GDP and the rise in the balance of payments deficit is to be reversed, British industry will not want its competitiveness weakened by higher interest rates putting more upward pressure on sterling. Slowing the consumer, therefore, could also hurt manufacturing.
It seems from recent experience, however, that the direct link between the exchange rate and small changes in interest rates has weakened. When interest rates fell by a third last year, from 6% to 4%, little happened to sterling. Moreover, since exports have held up rather better in Europe, where the pound has been strong, than in the US, where it has been weak, growth prospects overseas seem to matter more than the exchange rate.
For most of this year, the consumer is all that has stood between the UK and recession. But there are limits to how far personal spending, underpinned by borrowing, can be pushed. A rise in interest rates together with next year’s increase in National Insurance Contributions will reduce disposable incomes and slow consumer activity. In practice, employees’ NICs may rise by 2%, rather than 1%, in 2003 as companies pay higher charges out of lower pay settlements rather than profits.
The authorities clearly expect the gap to be filled partly by Mr Brown’s spending on public services, and partly by the corporate sector exporting and investing more. Much of this depends on the strength and pace of recovery in the US and Europe. Until a clearer picture of the international outlook emerges, the Bank of England is likely to delay a rate rise. With few inflationary pressures in the pipeline, this is not a problem, but the next move in rates will be upward.
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