On Tuesday, a statistic came out, completely unnoticed amidst discussion of falling house prices, rising fuel bills, and Labour leadership crisis. This statistic told us that broad money (M4) growth in the UK was 1.8% in June, and 11.4% in the year to June. Why should you care about that? Because, if this is not shown to be an odd statistical blip by the next release on September 1st, it will mean that this autumn interest rates will rise significantly and taxes will be cut significantly. Do I have your attention now?
Those of you that read the business pages may be aware that in recent Shadow Monetary Policy Committee (Shadow MPC) meetings, I have voted to hold rates, with a bias to cut. Indeed, that continues to be my position. Just for once, I have been expecting the MPC to agree with me on policy, though for reasons that will become obvious not agree with my position in toto. My position has been approximately as follows:
- Current inflation reflects the failure of the MPC to raise rates nearly sufficiently in 2006 and 2007. This was a significant, predictable, and predicted consequence of a straightforward policy error.
- This policy error combined with the failure of the political authorities to either enforce or modify the target, has destroyed what was previously the UK's inflation target - a requirement that inflation be 2% in the medium-term and not above 3% or below 1% in the short term - putting us into a no-man's land in which we have no idea how high inflation is permitted to go in the short-term before the targeting regime requires interest rate rises.
- Since we have no inflation target, there are no tactical benefits available from seeking to set policy so as to meet the target. Instead, for now at least, we operate in a regime of discretion.
- Given that our current monetary policy regime is discretion, we should consider policy in the round, and the nature of current economic shocks.
- Current rising inflation is heavily driven in the short term by the path of oil prices.
- A significant slowdown in GDP growth will tend to reduce inflation.
- Plunging house prices will be disinflationary.
- Broad money growth has largely disappeared, driven by problems in housing and credit markets.
- Higher inflation in autumn 2008 might lead to rising inflationary expectations and these might result in non-trivial wage rises over winter 2008/9. Because of the disinflationary forces described above, contrary to much press commentary the result of rapid wage rises will not be inflation (a comically naive idea that serious economists thought everyone had given up on around 1979, and which it is extraordinary, absolutely extraordinary, to find coming out of the mouth of a British Chancellor) but, instead, unemployment. Real wage rises make labour unattractive as a factor of production, relative to other options. The result of excessive wage demands is that labour becomes over-priced, and the result is unemployment. This unemployment will further accentuate deflationary pressures.
- Thus, though inflation will rise - perhaps now exceeding 5% - my position has been that in the medium term it would fall back, and since there were no gains to fighting it in the short term (there was no inflation target any longer to defend) there was no point in raising rates. On the other hand, to cut rates might exacerbate rising inflationary expectations, resulting in wage rises and hence unemployment. So, better to hold until inflation peaked, then cut aggressively to catch up with the significant disinflationary forces there would be in play over the two years thereafter.
A key step in this reasoning was the point about broad money that I italicized. If broad money growth were more rapid than I had thought - if financial market and housing market problems had not led to the fall-off I had anticipated - then interest rate policy would need to be tightened until, indeed, broad money growth did fall off in the way that I thought it had.
Here is the kind of chart I was relying on - it's from the Bank of England's provisional estimate for May 2008 of broad money and credit growth.
The blue line here gives the annual growth rate of broad money. Something like an 8.5% annual growth rate in this is compatible with a 2% inflation target. Because it fluctuates a bit, growth of up to about 10% over an extended period would not be too much of a concern. In 2006 and into 2007, this was growing at some 13-14%. Even many of that majority of economists that would disavow the stricter forms of monetarism were concerned by such rapid monetary growth, right up to Mervyn King himself who expressed extended concern about it and commissioned a specific Bank of England study into the role of the money supply.
Following credit market problems in mid 2007, broad money growth fell off rapidly in late 2007, as we can see on the pink 3-month line. Some extreme actions by the world's central banks reversed this fall-off at around the turn of 2007/8, but then it seemed that the fall-off in broad money growth had returned. This had transformed a number of those that followed money growth closely from the hawks they had been in 2006 - pressing for interest rate rises - to doves in mid-2008 - opposing rises and suggesting that there should be scope for aggressive cuts soon.
But the June figure returns that pink line back above the blue one in June 2008. Far from money growth falling away - virtually to zero, on adjusted figures as analysed by some economists - with predictions that the UK would follow the US into negative broad money growth; far from that, rapid broad money growth would have returned.
But if money growth is rapid, then oil price rises and wage rises might be a leading indicator of further rapid price rises. Instead of being deflationary in their impact, as they would be in a tight money environment, they might pre-figure inflation to come - if shops put up their prices, there would still be the money there to buy. In that case, inflation rising above 5% would necessitate interest rate rises, perhaps several of them.
This is far from certain. We must not over-react to one month's statistics, and I have so far stuck to my hold-then-cut position. Much data is volatile at the moment - for example, retail sales exhibited their sharpest recorded one-month rise in May, 3.6%, followed by their sharpest recorded one-month fall in June, -3.9%. Obviously neither of these data is quite right. Perhaps it will turn out that the June broad money growth data was a one-month blip, and the slowdown in broad money growth will return. Matters should become clearer on September 1st with the release of the July broad money growth figures. If it is not a blip, and broad money growth is still rapid, then there will surely be rate rises from September on.
Interest rate rises in this environment will force an even more spectacular variant of a strategy already under consideration. I have written previously that it was a mistake for Cameron to say that "the cupboard was bare" and that we could not cut taxes - indeed, might even have to raise them - in the current environment. I argued that that thinking reflected the bankrupt paradigm of Gordon Brown's fiscal rules, rules that never had any merit and have long been an embarrassment to all. The abandonment of the fiscal rules will allow the Labour government - probably more so, if no longer under Gordon Brown, but in some form even under him - to cut taxes and run a fiscal deficit as a means to respond to the GDP slowdown.
This will happen, I think, even if interest rates are kept on hold. But the scale of it may be much greater if interest rates rise. We could easily be talking of a fiscal deficit of £80bn-£100bn, generated by large tax cuts. This will not obviously be economically inappropriate. I shall write on this in more detail another time, but a credit crunch is the textbook time in which even economists normally sceptical of fiscal policy might recommend its use. The reason is that the government, in these circumstances, is better able to borrow than the private sector. (This leads to a debate about whether the government is better advised to draw on its greater credit-worthiness by providing guarantees for particular enterprises and sectors - e.g. a guarantee of the mortgage market, as some have suggested - or by borrowing to fund tax cuts. I shall explain my preference between these another time.) If private credit markets are damaged in the short-term (if that is the right analysis of the current environment, upon which I shall comment anon), there is a strong case for the government to do that borrowing for the economy that the private sector is unable, temporarily, to do. Furthermore, UK public debt is low, not high, by international standards. Many economists will line up (me included) to say that a deficit of £80bn-£100bn is affordable in the short term and might well be worth a try. Such a deficit would be broadly of the same order as the deficit the Conservatives ran in the early 1990s. We did it. They can do it too.
That will leave Cameron and Osborne with a problem. Of course, they can say "It's a damning indictment of the Labour Party's economic management that they got into this mess." And that may well be true, and people may have some sympathy. But suppose that it isn't Brown and Darling in charge any more then, but, instead, Miliband - either as Chancellor-with-a-free-hand or even Prime Minister. My guess is that he will say: We are where we are; this is our solution; you have previously said that you would not cut taxes; were you wrong before - in which case why should people believe you on the economy? - or are you going to oppose our tax cuts now? If you oppose us, what is it that you suggest doing instead? And in the meantime, lots of traditional Tory tax-cutters will be urging that we should cut taxes now as a device to create pressure for expenditure restraint (or even cuts) later. We will be split; Labour will be united.
Significant tax cuts would present us with a key strategic quandary. Having made the silly and unnecessary mistake of painting ourselves into this corner, we need to be anticipating, now, that this is what will happen in the autumn - in some form even if interest rates do not rise and even if Gordon Brown stays; in spades if Gordon goes and interest rates rise. What's the plan? What should we say and do then?
