Britain should resist further cuts in interest rates

Having spent much of the last 12 months preparing for a recession, economic analysts have been busily upgrading their forecasts for British growth in recent weeks. In a surprising about-turn, the economy appears to be moving into recovery mode with manufacturing looking decidedly less downbeat while the consumer has the financial firepower at its disposal to push activity on the high street significantly higher. A growth forecast of 1 per cent for 1999 now seems sensible. Given the fears that Britain was headed for a deep slowdown, such a result should be greeted as a pleasant surprise.

Since the Second World War, it has been safe to assume that a recession lay in wait at the end of each and every economic cycle in Britain. In the good old days when control over both fiscal and monetary policy rested in the hands of the chancellor, the economy could be manipulated into a nice boom ahead of each general election. Once returned to office, the chancellor would then be forced into aggressively raising interest rates to dampen the inflationary pressures which the pre-election policies had unleashed. After a few months, the tightening of monetary policy would be followed by rising unemployment, collapsing growth and occasional house repossessions. Small wonder that Britain had one of the most volatile economic cycles in the developed world.

The current cycle will not end in a recession because of the improved quality of economic management and Britain appears to have left its boombust tendencies behind. The New Labour government can rightly claim some of the credit for this welcome development.

Within days of taking office, the Chancellor handed policy independence to the Bank of England and gave it a free hand to hit an inflation target. Moreover, Mr Brown's budgets have been characterised by their conservatism and he has maintained a broadly neutral fiscal policy despite the buoyancy of the exchequer.

However, Mr Brown can't monopolise the praise for better policy management. One person who has missed out on his share of the credit is Mr Ken Clarke, the Conservatives' last chancellor, who should be commended for his budgetary restraint.

With the Tories languishing in the polls before the last general election and clearly on the way to a hiding to nothing, Mr Clarke must have come under massive pressure to loosen the budgetary purse strings in an attempt to calm the voters' fury.

Not only did he resist the pressure, he actually increased interest rates six months before the election. While sensible policy management may have matured under the Labour Party, it had its genesis in the final months of Mr Major's administration.

While policy management has improved significantly in the past few years, it is not without its flaws. The Bank of England has not been afraid to behave capriciously on the policy setting front with a phantom boom encouraging the members of the Monetary Policy Committee to push rates up from 6.25 per cent to 7.50 per cent in its first 13 months of independence.

While wobbles about the tightness of the labour market, rising earnings growth and consumer spending underpinned the bank's decisions, the hard fact is that the economy has been slowing down since the first quarter of 1997.

It is now clear that the bank overdid the monetary policy tightening of 1997-98 and as a consequence has had to slash rates by a cumulative 2.25 per cent over the past nine months. From a credibility viewpoint, the Monetary Policy Committee is fortunate that it has been able to use the emerging markets crisis as a cover for its rate cuts.

They don't want to be reminded that a 0.75 per cent rate reduction was sufficient to shield the US economy from the crisis while the beleaguered German economy has had to make do with a 0.80 per cent loosening of policy. With memories of the Asian/Russian/Brazilian crisis fading, the bank is now using the stubborn strength of sterling as a potential driver of further rate cuts.

The MPC should now pause for breath and survey the economic landscape. The members of the MPC may be surprised to see a pretty robust domestic economy. Unemployment is standing at 4.5 per cent, average earnings growth remains strong and inflation stands marginally below the government's target.

Moreover, with consumers enjoying the benefits of sharply lower interest rates and the absence of a fiscal drag, retail sales activity is bound to surprise on the upside as this year progresses. While weak external conditions will restrain overall growth, domestic demand is set to move into 2000 in robust shape.

Against this backdrop, the bank should resist the temptation to cut interest rates again. By confusing over-activism for policy flexibility, the Monetary Policy Committee increases the risks of Britain returning to the boom bust cycle next year.

Colin Hunt is chief economist at Goodbody Stockbrokers