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Adviser  >  News  >  August 2008  >  Economic Matters - Ian Kernohan, Chief Economist for RLAM

Economic Matters - Ian Kernohan, Chief Economist for RLAM

While there are some similarities between the current inflationary environment and that of the 1970s, there are important differences. Nominal (or money) GDP growth was already growing fairly rapidly in the years leading up to the oil shock of 1973, which then poured petrol on a smouldering inflationary fire. When mixed with a cocktail of heavy unionisation and wage indexation, the result was a pretty spectacular inflation explosion.

With recession looming, the government is likely to announce an easing in the fiscal rules and allow the automatic stabilisers to do their stuff.  No doubt the MPC will follow developments very closely and the main issue for them will be public spending plans.  If spending plans stay more or less unchanged but are funded by more borrowing rather than tax rises, then the implications for monetary policy are limited.  If however, the government seeks to boost the economy through faster growth in public spending, this will be met by tighter monetary policy, which may involve higher interest rates.  There is no easy way out for the government: the economy needs to slow down because inflation is so far above target.  Trying to prevent the slowdown will only prolong the problem.

Conditions today are somewhat different: nominal GDP growth has been relatively subdued for some time, there are few signs of serious wage pressure and while anecdotal evidence suggests growing labour unrest, it's on a completely different scale to what we saw in the 1970s or indeed the 1960s, when "Everybody out!" was a common cry on the shop floor.

Interest rates will be cut before Christmas

With at least one MPC member voting to raise rates in July, the odds of an August increase have certainly risen, however we still believe that the next move is down. The MPC has no need to prove its inflationary mettle as the economy slides towards recession. If it were not for the fact that inflation is so far above target, it would now be slashing rates, Fed-style. The fact that it has chosen not to do so shows how seriously it takes the inflation target. Lower inflation in the future means slower economic growth now and as this is exactly what is happening, there is no need for overkill. Also, to raise rates in August and then have to cut them within a matter of months would look clumsy. With the huge benefit of hindsight, the August 2005 rate cut now looks to have been a policy mistake; the MPC doesn't want to make the same error in reverse.

The implications of rate cuts for gilt markets are easier to call than for equities: we think bond yields will fall and the curve will steepen. For equities, some will take rate cuts as a trigger to buy into so called "interest rate sensitives". However, the problems which the UK economy faces are more protracted and not easily solved by a few rate cuts.  Post the Exchange Rate Mechanism (ERM) debacle, interest rates came down a long way, inflation fell, sterling fell and, most importantly, the build up of consumer debt could pick up from where it left off in the late 1980s. This time around, it's best to plan for a prolonged period of weak growth and such an outcome would favour defensives and growth companies rather than cyclicals or interest rate sensitives.

Proposed changes to fiscal rules

With recession looming, the government is likely to announce an easing in the fiscal rules and allow the automatic stabilisers to do their stuff.  No doubt the MPC will follow developments very closely and the main issue for them will be public spending plans.  If spending plans stay more or less unchanged but are funded by more borrowing rather than tax rises, then the implications for monetary policy are limited.  If however, the government seeks to boost the economy through faster growth in public spending, this will be met by tighter monetary policy, which may involve higher interest rates.  There is no easy way out for the government: the economy needs to slow down because inflation is so far above target.  Trying to prevent the slowdown will only prolong the problem.