Bank of England walks interest-rate tightrope

The outlook is beginning to look decidedly unsettled for the British economy for the rest of this year and moving into 1999. A few elements are combining which could cause a downturn in its fortunes. The latest twists in the Asian crisis, the shakeup of public spending plans and the unexpected rise of interest rates in June, pose a threat. A hard landing for the British economy is now a risk. If this happens, then sterling would depreciate significantly from its current highs, pushing the pound up strongly against it. The June interest-rate rise surprised the markets and while higher-than-expected average earnings data did justify the increase to some extent, there are doubts about how much more monetary tightening the economy can take.

The Bank of England's main interest-rate setting group the monetary policy committee (MPC) is concerned that the labour market is tighter than it had originally thought.

One of the key reasons behind its June decision to raise interest rates, was the sharp acceleration in wage growth and the fall in sterling, which dropped as much as 6.5 per cent on average against other currencies over two months.

And if comments from one committee member, Professor Charles Goodhart, are anything to go by, there is still consternation that there is no turn around in the labour market.

Professor Goodhart voted against a rate hike in April and May, having canvassed for one at the first three meetings of the year.

The monetary policy committee believes that a 4.5 per cent growth rate in average earnings is consistent with the inflation target of 2.5 per cent. The 5.9 per cent earnings growth in March was significantly higher than this and prompted the latest rate rise.

The June rate is 5.4 per cent, higher than expected , although many expect the headline rate to fall back as bonuses feed out of the number in months to come. The August inflation report will also be very important in consolidating the market's expectations. So far, the economy seems to be growing faster than forecast in the May report. At that time the Bank of England believed the economy would slow to record growth of 2 per cent a year and warned that it might even be less.

However, this forecast is now likely to be overshot and while growth will slow, it will do so from a higher than expected rate. Meanwhile, the latest figures from the Confederation of British Industry suggest that retail sales have peaked.

But this may not be a quick enough slowdown for the Bank's monetary policy committee (MPC). It has known for some time that the manufacturing sector is technically in recession. The service sector, however, is still attracting growing employment. And the latest interest-rate rise may actually widen the gulf between the external and domestic sectors even further, as sterling now seems likely to stay stronger for longer than many exporters at least had been hoping.

Most observers now believe that the committee would actually like to see a period of below trend growth so as to meet the inflation target.

And it is possible that the last rate rise may have done enough. Consumers are becoming gloomier about economic prospects and the housing market is thought to have slowed sharply in June, although some observers put this down to the World Cup.

But as Ms Alison Cottrell, chief international economist at Paine Webber, points out, newly independent central banks tend to keep pushing up interest rates until they can be sure they have done enough, which is usually when they have done too much.

Since it is the scale of the slowdown rather than its existence that is in dispute, any further rate hikes are likely to exacerbate the slow down and increase the risk of a hard landing, she points out.

It is possible that once this becomes obvious, possibly by early next year, the Bank of England, will deliver significant interest rate cuts to stop the hard landing turning into full-blown recession. But cuts in the meantime are probably unlikely, even if average earnings fall back and the latest earnings figures have put a further rise back on the agenda. The shift in the committee's voting from seven to one against a rate increase in May to eight to one in favour in June, suggests that the MPC may be quite trigger happy and some members at least can be swayed by single pieces of data. Strikingly, some even questioned whether the 0.25 point rise implemented after the last meeting was enough.

There is also a question about how seriously the MPC has taken the impact of the Asian crisis so far. While the Asian crisis has been emerging for some time the recent further deterioration is likely to prove negative for Britain. The current account began this year by falling back into the red as the Asian crisis and the strong pound made themselves felt. And the weakness of demand in the region is continuing to feed through to British exports to the region which have fallen by close on 30 per cent during the past year.

Imports have not yet begun to soar, but many believe it is only a matter of time before the combination of robust consumer spending in Britain and the depreciation of Asian currencies and the price of their goods feeds into higher imports.

Already the downturn in overseas trade has knocked about three-quarters of a per cent off growth in the economy overall. But there are other upward pressures on interest rates and thus on sterling over the coming months, including the minimum wage.

Up to now the Bank of England has excluded any minimum wage impact from its inflation forecasts, so even the £3.60 an hour which was in line with expectations is likely to mean an upward revision for the central bank's inflation expectations. This is likely to add about 0.6 per cent to the average pay bill.

But many firms are likely to gradually increase wages to this level and it is possible that some of this has already happened, which may account for some of the increases in average earnings already seen.

The other influence will be the new public expenditure plans, which will mean a significant loosening over three years from next year.

In the long term, these policies should stimulate the economy. However, economists such as Mr Roger Bootle of HSBC point out that over a shorter time frame, their impact could be far less positive, if the trade off for looser fiscal policy in the future were tighter monetary policy over the next year or so.

Overall, the MPC will continue to walk a difficult tightrope between raising rates to head off inflation and possibly cutting them next year to stop the manufacturing recession from spilling over into the entire economy.

And their management will be important for Ireland, as Britain remains the largest export market for Irish goods, while the trend in sterling will also remain a key influence for our economy.