Outlook: MPC should err on the side of hawkishness

ON making interest rate judgements and the conditions for aid in the far east

It gave us a breather this month, but will the Monetary Policy Committee put interest rates up in February instead? Unlike all those analysts in the City who sound utterly certain about whether and when and how much further borrowing costs need to rise to keep inflation on course, the MPC displays a becoming modesty about its ability to see into the future.

We live in challenging times. Diverging patterns in different areas of the economy make it unusually hard to be confident about the rate of growth in the next year. On top of that there is a big crisis taking place in the world economy the consequences of which are impossible to predict. In these circumstances even the best forecasts are almost bound to go awry.

And - as some of the country's most prominent economic forecasters spelt out at an Economic and Social Research Council-sponsored conference in London yesterday -- predicting future growth and inflation has to battle against frequent revisions to past data, ignorance about the true structure of the economy and pure bolts from the blue in the shape of unforeseen events. Any claim to certainty is bogus.

So, even without having overheard the MPC's meeting this week, it is easy to sketch out the discussion. On the one hand, the strength of the pound has depressed manufacturing and is starting to squeeze recorded export growth. The contribution from trade to growth will decline sharply, especially against the background of the Asian crisis. This will keep global inflationary pressure weak. To purely domestic monetary considerations, the Bank must also now add its responsibility to join other central banks in helping stabilise the world's financial markets.

On the other hand, spending in the shops and the two-thirds of consumer spending that occurs beyond the high street are displaying strong momentum. Pay settlements are creeping up, with January an important bargaining month. Employment continues to climb and people still have the pleasure of last year's windfalls swelling their bank accounts. The boom may be over, but spending is not about to nosedive.

Weighty evidence is probably required on one side of the balance or the other to justify action on interest rates --whether up or down - but it will always be a question of judgement in the end. For what it's worth, the Committee should for the time being continue to err on the side of hawkishness. The point of having an independent central bank - especially in a historically inflation-prone country like the UK - is to be better safe than sorry. At this stage the risks of an overly lax monetary policy still outweigh the risks of an overly cautious one.

Moreover, policy makers need to be far more concerned nowadays with the precise makeup of what inflationary pressures there are in the economy in making their interest rate decisions. Deflationary pressures in the world economy, and the strong pound, may be disguising a build up of inflationary pressure elsewhere - in wages for instance.

Severe wage inflation alongside falling prices for goods and services make a particularly dangerous combination with possibly serious consequences for long term growth and employment. This is the bogeyman the monetary policy committee must most fear. Unfortunately it is not at all clear what the Bank's policy response ought to be should such a spectre make an appearance. This is unknown territory, even for central bankers with long experience of control over interest rates. For the newly independent Bank of England, devising the correct response is going to be of vital importance.