The need for a faster growth strategy

Ahead of the wholesale price numbers yesterday, the market thought it was odds-on for an interest rate cut following the meeting between the Chancellor and the Governor tomorrow. When the goodish figures were published it managed to convince itself that a half point off base rates had become a near-cert.

Some sort of base rate cut feels right, principally because the market will accept it. The balance of fear between renewed inflation and a new Europe-wide recession (actual recession on the Continent, very subdued growth here) has shifted towards the latter. The Bank, however, will continue to lean against inflation, as it must, and may be able to hold down the cut to a quarter per cent. That might disappoint the markets, but politically it would be astute for the Chancellor to accept that advice. The less he cuts now the more he may be able to do so in the future.

The underlying point here is that world interest rate pressure has clearly eased. Germany is going to cut rates soon, for last week's figures on manufacturing output revealed that year-on-year there was a sharp downturn in domestic sales, so that despite strong exports, overall output was down. The obvious trigger for easing in Germany is this week's Bundesbank council meeting, but even if this does not sanction a cut, expect some easing early next year. In the US there is no expectation of a tightening of monetary policy and the bond and equity markets have been whizzing ahead on that basis.

Against this background some cut in UK rates really does seem likely. But of course we are just talking about a modest shaving of one particular interest rate. On a long historical view it matters not one jot whether base rates go up, down or sideways as a result of this particular meeting. What matters is whether the long-term trend of inflation (and hence long- term interest rates) continues to be down.

The long-term context into which this decision fits is shown in the graph, which shows both inflation and interest rates in the Group of Seven nations since 1960. Three messages from that graph are very clear.

One is the clear upward trend of both lines until the late 1970s, with the twin peaks of inflation, and the upward pull this exerted on bond yields. The second is the clear downward trend of both lines since then. And the third is the extent to which the natural relationship of positive real interest rates has been restored. That long-term interest rates have to be positive was evident in the 1960s, but in the 1980s the gap between the two has been much larger. It is as though the unpleasant experience of negative real rates in the 1970s has to be paid for: the markets are in a way getting their own back.

This is not a British issue; it is a global one. We may or may not do a bit better than the rest of the pack, but the differences will be less than the similarities. However it does affect Britain, for if the long- term trend of inflation continues down, so too will our bond yields and so too will short-term interest rates.

In other words, if that downward trend on the right hand side of the graph is secure, Mr Clarke will eventually achieve his desire of lower interest rates, and Mr George will achieve his desire of lower inflation. The only difference is that the former may not be in office to enjoy it.

Whether the downward trend is indeed secure of course depends on the grand forces of the global economy - in particular the continuing downward pressure on the price of goods caused by new, low-wage entrants into the world market, the relentless drive to improve the efficiency of the developed world in response, and the discipline exercised by financial markets on governments which fail to deliver an acceptable inflation performance. Looking ahead 10 or 20 years the balance of probability surely is in favour of still-low global inflation, maybe no inflation at all, maybe even a long period of falling prices, similar to that which occurred in the last century here in Britain, or is taking place in Japan now. However that would hardly seem to be relevant to inflation and interest rate prospects in any one particular G7 economy in the next few weeks or months.

But in a way it might be. Consider this. There is widespread evidence of a sense of growing insecurity throughout the UK economy. This is reflected in low wage awards, in still subdued house prices, in the inability of many producers and retailers to make price rises stick. You can see this in the shops now, for already there are a sprinkling of pre-Christmas price reductions or other special discounts. This would have been unheard of, five or 10 years ago.

This is not a climate in which it is dangerous to cut rates. If this were France and special interest groups were seeking by force to increase their share of the cake at the expense of others, then it would be dangerous to risk a low interest rate policy. But we clearly are not in that boat. Indeed one could put the point round the other way. It is not just possible to risk faster growth here than one could do in a more rigid, less market- disciplined economy; it is actually necessary to try to achieve faster growth because of the increased insecurity of people in such an environment.

Such a policy has worked in the US and there is no reason to suppose it will not work here too. Expect the cut in base rates soon.