Revival poses tough choices

How times change. A few weeks ago, gloom enveloped all discussion of the prospects for economic recovery this year. Now, a robust upswing is taken for granted, and the financial markets have started to worry about the return of inflation. In fact, the forward interest rate contracts in the markets show base rates remaining at 6 per cent until the year end, and then rising to 7 per cent by the autumn of next year.

It certainly seems to be a case of 'third time lucky' for the recovery. After false starts in the autumn of 1991 and the spring of 1992, the evidence of a strong bounce in activity in the last three to six months is irrefutable. The data we have so far for the first quarter of this year show that manufacturing output is 1.8 per cent above the previous quarter's level, while retail sales volume is up by 1.7 per cent. This indicates that the goods-producing sector of the economy has surged during the first quarter and, even allowing for the fact that the services sector will have been much more subdued (it always is, at least as measured in the official statistics), non-oil GDP will probably have risen by about 0.8 per cent during the quarter.

Policy eased

The Goldman Sachs Activity Index now shows that the economy probably bottomed out in the autumn of 1991, with a gradual but clear recovery occurring before sterling's departure from the ERM last September. Since then, there has been a very sharp further easing in policy - base rates have fallen by four percentage points, sterling has dropped by 12 per cent, and the fiscal stance has eased by around 1 per cent of GDP in 1993/94. Given that the economy was clearly recovering before this easing took place, the recent surge in activity should not be too surprising.

The inflation picture is harder to read. The underlying retail price index (excluding mortgage rates) has now recorded back-to-back increases of 0.7 per cent a month in both February and March, which on the surface looks troubling. Furthermore, there are anecdotal reports that price increases for basic materials (such as steel) are now beginning to stick.

But some pass-through of higher import prices after sterling's devaluation was always likely, and so far it has been very modest. If we strip out all the lumpy and volatile items of the RPI, and seasonally adjust the remaining index, we find that the up- to-date running rate for core inflation (three-month annualised) is currently 3.7 per cent, about 1 per cent higher than it was last autumn.

This rate may rise a little further over the next few months, but inflation cannot take off for any length of time while the labour market remains depressed. So far this year, basic pay settlements have averaged only 1.9 per cent, the lowest for four decades. Admittedly, this average has been greatly affected by the Government's pay ceiling for its own workers, who have been settling at 1.6 per cent. But in the private sector, basic settlements have dropped to 3.1 per cent, which should ensure that unit labour costs in the whole economy are roughly flat this year.

Despite the strong disinflationary forces that are still coming from the labour market, the Government is obviously concerned that the devaluation's effects on import prices will be sufficient to threaten its 1-4 per cent inflation target in the coming months. This target, apparently set somewhat in haste after the ERM debacle, is taken with deadly seriousness by Treasury officials.

They have been relieved and somewhat surprised that the credibility of counter-inflation policy (as measured, for example, by the inflation expectations incorporated in the gilts markets) have remained extremely low in the wake of the devaluation, but they do not believe the credibility of policy would survive if the new inflation target were breached so soon after being set. They are therefore willing to contemplate an early tightening in monetary policy if necessary to keep inflation below 4 per cent.

However, by giving primacy to the inflation target, the Treasury is by implication limiting the degree to which the big structural deficiencies in the economy can be addressed. Correcting these structural problems may require a further sterling devaluation, but this would probably push inflation above 4 per cent, at least temporarily. Hence the dilemma.

The graph shows that the real exchange rate since 1979 has on average been 18 per cent higher than it was in earlier decades. Such a prolonged period of adverse industrial competitiveness should, according to the textbooks, have had several effects on the economy, all of them favouring consumption over production.

First, it should have shrunk the manufacturing sector (which depends heavily on trade with the rest of the world) relative to the services sector. This has indeed happened. The share of manufacturing in GDP has fallen from 29 per cent in the mid-1970s to 23 per cent now.

Second, consumption should have benefited relative to investment and net exports. Sure enough, it has. The share of consumption in GDP has risen by about four percentage points over the same period.

Third, the balance of payments should have worsened markedly. Again, the textbooks have triumphed. The trade balance, as everyone now knows, is running at its worst level since the Second World War, adjusted for the stage of the economic cycle.

Fourth, unemployment should have risen, at least for a transitional period. No one needs reminding that the jobless total has indeed more than doubled - with the 'transition' so far lasting almost 15 years. Finally, all this should have reduced the rate of inflation. And it has - by much more than anyone thought likely a decade ago.

Permanent shift

The high real exchange rate policy, which has been the distinguishing feature of Treasury strategy since the Conservatives came to power, has therefore delivered its main objective - low inflation - at the expense of an apparently permanent shift in the structure of the economy towards excess consumption and away from manufacturing, investment, exports and employment.

If the Government now reacts to a strong recovery in domestic demand by tightening monetary policy, it will push the real exchange rate up again and will in effect be announcing that the post-1979 thrust of policy is still alive and kicking. It will be saying that a further period of excess consumption, along with under-investment and under-employment can be expected, lasting for as long as the international financial markets are willing to finance the resulting trade deficit. On past performance this could be for some years. Nevertheless, the risk of a pre-election financial crisis would be quite large.

The alternative, which is also full of risks, is to accept that the structural imbalances need to be addressed now. But this would mean holding interest rates down, or cutting them further, to promote a further significant decline in sterling as the economy recovers. Sooner or later, that would mean abandoning the 4 per cent inflation ceiling. And it would definitely mean raising taxes much further to control consumption while base rates stay low.

It is a tough choice. I would incline towards the latter path - low base rates and higher taxes - but I can quite readily see why a Conservative Chancellor might veer in the other direction.