Interest Rate Cuts Research Articles

The London Business School with Gower Publishing

The knives are out for the Chancellor whose opinion poll ratings are at a record low level. He is being personally blamed for the Conservatives' poor showing in this month's elections and, according to newspaper reports, is certain to lose his job in a Cabinet reshuffle, probably in the summer. Mr. Lamont has presided over the UK economy over a difficult period ‐ though many of his policies and problems were inherited from his predecessor (Mr. Major) ‐ and arguably he should have resigned last September following the failure of the ERM policy and the huge cost of intervention. Since then Mr. Lamont, probably on the advice of his Treasury officials, has followed a determinedly non‐populist approach, notably on public spending last autumn, interest rate cuts earlier in the year and tax increases in the Budget. But, as economic recovery becomes better established, and the focus turns to the structural problems of the British economy, it is evident that some very tough choices will have to be made. Over the medium term the balance of payments and public sector deficits are going to have to be tackled which means devoting resources in the first place to exports and investment, not to consumption. This means no more interest rate cuts, higher taxes and public spending cuts, which Mr. Lamont has already shown he is willing to implement, and requires a Chancellor who is able to stand up to the more populist and erratic approach of the Prime Minister. The danger would be that a new Chancellor, seeking to court popularity in a way that Mr. Lamont has not, opts for the easy alternative in the short run ‐ to the longer‐term detriment of the economy. Almost by definition, certainly in the absence of either an independent Bank of England or an external exchange rate constraint, only the Treasury can take the tough line and so the Chancellor has to be unpopular ‐ Nigel Lawson's best received Budget, that of 1988, is now universally damned. Mr. Lamont may be about to be buried but he should be praised for taking the non‐populist line.

A Proposed Framework for Monetary Policy

Leave the ERM, cut interest rates and let the pound find its own level⃛ it's the cut and run option. The credibility of our anti‐inflationary strategy would be in tatters. And quite soon interest rates would have to go back up again ‐ Norman Lamont, in a speech to the European Policy Forum, July 1992.

Economic Outlook 1991–1995: The London Business School with Gower Publishing: Forecast Release: THE CHANCELLOR'S ECONOMIC ADVICE

Within the last month the Chancellor has made two important speeches on macroeconomic policy. The first, to Surrey businessmen in June, pledged the UK to the French route to a ‘virtuous circle of low inflation, rising competitiveness and increasing market share’; the second, in July to the European Policy Forum, vigorously defended his present policy against the alternatives, which he dismissed as ‘illusory or destined to fail’, of devaluation or cutting interest rates. On both occasions Mr. Lamont placed the permanent conquest of inflation at the centre of his policy, arguing that holding sterling at its present central parity of DM 2.95 is the only way to achieve this objective. In his view the consequence of any of the alternative proposals would be ‘either higher interest rates, higher inflation, or most likely both’. In this Forecast Release we consider these claims and the economic advice on which it is based. On the latter we would surmise that the thrust of the advice which Mr. Lamont is receiving is that he has the opportunity to deliver a sustainably low inflation rate and that this requires a stable pound within the ERM. The alternatives involve a sterling devaluation which, no matter how obtained, would obstruct the goal of permanently low inflation in return for only transient benefits on output and unemployment. But the price of defeating inflation has been high and is not yet fully paid. Moreover the goalposts have been moved: to reach the French position on competitiveness, which underpins their gains in market share and which has taken the best part of a deeade to achieve, requires a still better inflation performance on the part of the UK and while this is being achieved, adjustment costs will persist. It is partly in defence of his own policies and partly in an attempt to moderate the already-high adjustment costs that Mr. Lamont has adopted a more combative stance. His advice is that to compete with Europe, we cannot award ourselves pay increases far in excess of European levels, indeed we need a period of below-average pay rises.

THE ECONOMY AFTER THE ELECTION

With the election out of the way and signs of recovery tentatively in place, the Government is likely to take steps to bring the economic and political cycles back into kilter so that it does not have to fight the next election under the handicap of recession. This suggests that its first priority will be to consolidate the progress on inflation with a tight fiscal and monetary stance, deferring until 1993‐4 any significant relaxation of policy. Holding the exchange rate close to its present parity will therefore take priority over interest rate cuts which may have to wait on a lead from the Bundesbank. On fiscal policy the aim will be to reduce the budget deficit, which suggests a tough approach to public expenditure in this year's spending round.

Chapter II. The World Economy

Business cycle developments in the major seven economies have not been particularly well synchronised in the last two years. The US, Canada and the UK have been in recession, whilst Germany and Japan have been growing strongly. We are predicting that this asynchronicity will continue over the next eighteen months, with growth slowing in Japan and Germany whilst a mild recovery takes place in the English speaking world. However there are some signs that the recovery, at least in the US, is likely to be rather slower than we had anticipated in our August forecast. The Federal Reserve in the US has clearly been concerned about the most recent signals from the American economy, and it encouraged a cut in interest rates on 6th November. The Japanese authorities have also cut interest rates in this quarter, and we anticipate that there will be no substantial increases in German interest rates.

Economic Viewpoint The Shape of the UK Recovery

Monthly economic data combined with the more optimistic tone of CBI and other surveys suggest that the recession may be drawing to a close. By the early summer it was becoming apparent that output was no longer falling; now it appears that the economy is in transition front the ‘bumping along the bottom’ phase, which lasted through the summer months, to the beginnings of a modest recovery in output and demand. The focus of interest is therefore switching away front the timing of recovery towards its shape and strength. We have previously argued that the recovery would be led by consumer spending, that industry would not resume investment spending un ti1 demand elsewhere was picking up, and that although exports have held up remarkably well, taking some of the strain of the downturn in domestic demand, there was little prospect of a surge in world trade to provide the pre-conditions for an export-led recovery. What was and is needed is a recovery in consumer confidence, with a willingness to borrow at lower interest rates showing up in a reduction in the personal savings ratio. But the recovery starts with the personal sector still having a large debt overhang from the 1988-9 boom, which will inevitably inhibit new borrowing. Meall while the credit crunch is restricting the ability of banks to lend. Together these imply only a limited response to the interest rate cuts of the last year and would, in the absence of the EMS link with high German interest rates, argue for further interest rate reductions. But high post-unification German rates put a floor under UK rates and will slow the recovery. The economy will do little more in 1992 than make up for the output losses of 1991 and our forecast (as in June) suggests that it will not be until 1993 that previous output peaks are passed and unemployment is stabilized.

The Dollar, the Oil Price and Policy Divergence

There is currently a clear divergence of policy between the United States, Japan and Germany. With the US in recession and concern growing over the severity of the slump, interest rates have been cut in a move to revive the economy. In contrast Japan and Germany are both experiencing strong growth and monetary policy remains tight to combat inflation. This divergence was seen most clearly when the Federal Reserve Board lowered its discount rate to 6 per cent on 1 February, the day after the Bundesbank had raised its Lombard rate to 9 per cent. With G7 increasingly concerned about domestic factors, less emphasis is placed upon stable exchange rates and as a result the dollar is at an all-time low. The last two G7 communiqués have stressed ‘stability oriented monetary policies’, an ambiguous phrase which fails to define ‘stability’ either in terms of exchange rates, inflation or growth. Thus both the German and Japanese policy of high interest rates to reduce inflation and low US interest rates aimed at stimulating the economy can be termed as ‘stability oriented’. This analysis focuses on these divergent policy responses in two alternative scenarios to the world forecast we presented last month. The first scenario considers what might happen if the Federal Reserve Board were to stimulate the US economy by further cuts in interest rates, whilst Japanese and German rates were unchanged in the face of inflationary pressures. This case may be relevant if the recent US loosening of monetary policy is not sufficient to encourage growth because of a ‘credit crunch’, so that a more expansionary policy is required by the Fed. As a consequence, policy diverges further and the dollar weakens. The second scenario focuses upon a reduction in inflationary pressures in Japan and Germany brought about by an oil price fall. In this case we assume that US policy is already loose enough to avoid a prolonged recession, but that German and Japanese monetary policy is relaxed as inflationary forces recede. In this case policies converge. Each scenario thus concentrates on one of !he two features which are causing the policy divergence amongst G3 countries: recession in the US, inflation in Germany and Japan.

House Prices, Housing Investment and Demography Forecasts from the LBS/Abbey National Model of the UK Housing Market

A new housing sector has been incorporated into the London Business School model. This article outlines the new housing model, summarizes the research which has gone into its construction, and presents a forecast of the UK housing market. Using the new housing model, we forecast a moderate recovery in the housing market in the later part of 1991 and 1992. This recovery is however short-lived and does not result in such high rates of house price increase as previous house price booms (Chart 1). Cuts in interest rates following entry to the exchange rate mechanism of the EMS prompt a recovery in house prices from the middle of 1991. House price inflation then peaks with an increase in average UK house prices in 1992 of 11 per cent over the previous year. Increases in real personal disposable income are modest, by the standards of the 1980s, and for this reason the recovery does not develop the momentum of previous house price booms. House price inflation moderates again in 1993 falling back to around 7 per cent. Housing starts and housing investment recover only slightly from their present depressed levels. the recovery in house prices is weaker than that foreseen in our April Forecast Release. This is because real personal disposable income is now forecast to grow more slowly during 1991. Sterling's membership of the ERM is followed by a fall in interest rates, but it is the timing of interest rate cuts rather than their magnitude which differs from the earlier forecast. The changed profile of interest rates has altered the house price forecast only marginally.

WORLD OUTLOOK

The rise in the oil price since the Iraqi invasion of Kuwait in early August does not radically alter prospects for the world economy; rather it exacerbates existing trends. The US economy was, in any case, heading towards recession and a sizeable overshoot of its budget deficit targets. Japan, especially, but also continental Europe had still not reached the peak of the economic cycle so that inflation and interest rates were still rising. While the higher oil price adds to costs and prices in all countries, the policy response is unlikely to be unborn. In the US the adverse effects on output are being emphasized while elsewhere the inflationary implications are to the fore. In Japan, where acute labour shortages are emerging, the monetary authorities have already raised interest rates and we expect a similar response from the Bunds bank In the US such a move is unlikely; indeed once an agreement on the budget deficit is obtained between President and Congress, we would effect the Federal Reserve to cut interest rates. Despite this view on policy, the forecast offers little prospect of the US avoiding a pronounced slowdown and takes a gloomy view on US growth in the medium term. In Japan and Germany on the other hand the short‐term inflation outlook appears containable and growth prospects over the medium term robust. The central forecast is based on a $25 oil price; we explore in a simulation what might happen if the price rose to $45 a barrel for a limited period.

Chapter I. The Home Economy

Since last November we have based our forecasts on the assumption that the UK will soon become a full member of the European Monetary System. There has been no change in the official position on entry to confirm or correct that assumption, but recent hints and rumours make clear that it is the right assumption to make. We retain it for this forecast. The actual date of entry is now more likely to be in the first half of next year; a fall in the rate of inflation is seen as a precondition, and it is one which may not now be fulfilled as soon as we had hoped. We assume that some announcement on the ERM is made about the end of the year, permitting an interest-rate cut in the first quarter, followed by formal accession by the second quarter, about the time of the Budget.

West Germany

The government's argument that domestic demand is buoyant and that output is rising at a 3 per cent rate was vindicated by figures, for the second quarter. After a weak first quarter (partly due to another severe winter), GNP bounced back strongly and the annual growth rate reached 3.3 per cent, higher than the government's target of 3 per cent for 1986. This rebound, together with above‐target monetary growth explains why the German authorities continue to resist pressure from the US to cut interest rates. Despite the rapid volume growth of imports as demand picks up, the fall in their DM price means that the trade surplus is continuing to grow. The current account surplus of DM40.5bn for the first seven months of the year is more than double that in the equivalent period last year.