Clarke faces monetary decision

Kenneth Clarke has not yet taken a really tricky decision in his period at the Exchequer. This does not mean that he has ducked the difficult choices, just that most of the big decisions have more or less taken themselves.

For example, he knew almost immediately on entering office that taxes would have to rise in November, both in order to ensure calm in the financial markets, and to create room for tax cuts in the election run-up. He further knew that VAT rises were politically unfeasible, and that enough money could be raised from other less sensitive areas to fill the gap. He was also aware that he would be able to unveil 'surprising' public spending cuts to placate the Tory right on Budget day. One of the reasons for the political success of the Budget was therefore that the objective circumstances facing Mr Clarke were less difficult than many imagined.

Similarly with monetary policy. As Norman Lamont has correctly observed, the current stage of the economic cycle - a couple of years following the trough in output - is often the most benign for political reputations, since there is plenty of scope for unemployment to fall without triggering inflationary pressures. This raises no obvious need to change monetary policy, and lucky Mr Clarke has been broadly content to leave well alone on this front.

But it is not in the nature of economic policy that dilemmas can be avoided for very long, and for the first time in a while the Government is facing a very delicate choice on monetary policy. Put simply, the strength of recent activity data has been such that some Treasury advisers, scarred by the experiences of 1987-89, might be excused for thinking that a touch on the monetary brakes might soon be appropriate. However, the spectacularly good inflation figures in the past three months, taken alongside the firmness of the exchange rate, would appear to justify a cut in interest rates.

The reputational penalties for taking a wrong turn could be large. Too much tightness and the Chancellor will be branded as the man who was blind to the danger that tax rises could snuff out the recovery. Too little and history will say that he failed to learn the obvious lessons of the inflationary boom of the late 1980s.

It is a commonplace that political motivations usually dictate lower interest rates than 'sound economics' might suggest. But this may not apply today. Admittedly, from the Prime Minister's vantage point, a drop in base rates probably seems essential to sway the results of the crucial European and local elections this spring. But the personal interests of Mr Clarke - who will be taking the monetary decisions, without necessarily offering Mr Major much of an opportunity to contribute - do not obviously coincide with those of his boss on this. Bad election results this summer might prove to be Mr Clarke's only route into Number 10.

Furthermore, from the point of view of the Tory Party as a whole, the one thing that must be avoided at all costs is a premature peak in the upswing. If the recovery temporarily pauses this year, that will not necessarily be fatal for the Government. If the lid blows off another inflationary boom in 1995/6, it probably will be. It is far from obvious, then, that politics points to sharply lower base rates in the near future.

What about economics? According to the GDP statistics published on Friday, the non- oil economy is growing at an annual rate of only about 2 per cent, which is probably insufficient to sustain the recent decline in unemployment. But it is hard to avoid the suspicion that these official output figures may be understating the true rate of growth.

Monetary growth is picking up, both in the narrow and broader measures. Retail sales volume is rising at 4 per cent a year. Manufacturing output has shaken off the temporary torpor of last summer. Unemployment is declining as fast as it did at the peak of the boom in 1988, and unfilled vacancies are rising fast. Furthermore, the Chambers of Commerce survey - absurdly described by the Chambers themselves as 'weak' or 'patchy' - in fact showed that business confidence is as buoyant as it was in the 1988 boom.

If this were the whole story, there would be no economic case for a base rate cut - especially since about 8 million mortgage holders whose interest rates are adjusted annually are about to receive a large increase in their purchasing power. But the tax increases in April will depress GDP growth this year by about 1.5 per cent and, more importantly, the exchange rate is showing signs of rising in a way that may not be welcome to the Chancellor.

At one point, sterling's post-ERM devaluation amounted to 17 per cent, but this has now been whittled down to only 8 per cent. Furthermore, with Britain currently appearing (if only for a few months) as the stellar performer among the largest economies, sterling would certainly rise much further if the Chancellor refused to reduce UK base rates as European and Japanese interest rates continue to decline.

The balance of payments figures have come in much better than was generally expected lately, so there seems no urgent or compelling need to stop sterling rising. But these figures are heavily distorted by data imperfections, and we could wake up one morning with the Central Statistical Office informing us that the trend in trade has been much worse than we thought. Britain will probably still need a somewhat lower exchange rate over the medium term to produce a satisfactory trade performance (although I say this without ever having been an enthusiastic advocate of that policy of despair, devaluation).

The clinching point, however, is that for the first time for decades there appears no overriding need for a stable pound to produce an acceptable out-turn for inflation. The last few retail price figures have been much better than generally realised, and considerably lower than the Bank of England expected when it published its last inflation report in November.

The accompanying graphs show what the Goldman Sachs inflation model is currently predicting for the next few years on the assumptions of fast and slow GDP growth rates, and with four different scenarios for the exchange rate. Following the latest improved price data, it now seems that inflation could hover in the bottom half of the Government's target range in the next couple of years, and if sterling is allowed to appreciate, then inflation could conceivably drop below the bottom end of the target range before the end of next year.

It is therefore clear that fashionable comparisons between the present situation and the mistakes made when Lord Lawson 'shadowed the Deutschmark' in the inflationary conditions of 1988 do not hold water.

The Chancellor should surely cut base rates if, as I expect, sterling continues to rise.

(Graph omitted)