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Economy - Taking the Denis Healey approach to inflation

Central bankers are doing to inflation what Denis Healey allegedly wanted to do to the rich, says Sean Shepley. But the impact on economic growth in the UK next year may well make your eyes water.

Despite regular denials that he ever said it, Denis Healey is famousanted to do to the rich, says Sean Shepley. But the impact on economic growth in the UK next year may well make your eyes water. for the phrase “squeezing the rich until the pips squeak”. At the time, the debate was about the appropriate distribution of the tax burden, with Healey’s alleged desire to increase high income-earners’ contributions significantly – a position which the Labour party spent a decade regretting.

Today, the battleground has changed. Central banks have become the “pip-squeezers” and the target is inflation. UK interest rates are rising even though inflation (currently 2.7% excluding mortgage interest payments) is barely above the 2.5% target set for the Bank of England (BoE) by Chancellor Brown (2.5%).

Not only is there now widespread political agreement that price stability is a desirable objective but there is remarkably little debate about this year’s rate hikes even though current inflation and wages are well behaved.

Yet, the BoE should not be let off so lightly. After raising interest rates by 0.25% earlier this year, Federal Reserve Chairman Alan Greenspan was hit by a wave of criticism. “Growth is not the enemy” went the political argument and ever since, Greenspan has been prepared to tolerate strong growth as long as wages are sufficiently benign to allow productivity improvements to hold prices in check. (Instead, he has turned his attention to warning about high equity valuations, but that’s another story.)

In many ways, US and UK economic circumstances are very similar. Both countries are experiencing strong growth, tight labour markets (on comparable definitions, US unemployment is under 5% compared with 7% in the UK) and low inflation. Yet, even though the degree of inflation risk looks similar, the policy response is totally different; the Federal Reserve is prepared to tolerate strong growth provided inflation stays low; the UK authorities aren’t.

What is going on and does it matter?

At least part of the answer is explained by “reputation”. Over a number of years, through the correct response to economic shocks and crises, Greenspan has developed an enviable reputation. The bond market is prepared to trust that, should the evidence change, Greenspan will be quick to act. Unfortunately, the BoE does not enjoy Greenspan’s reputation. Not only because its authority to set interest rates is barely six months old but also because the track record of its advice under Chancellor Ken Clarke was rather mixed – Clarke overruled the BoE on more than one occasion and was considered by the bond market to have been “justified” by subsequent data. Hence, the BoE is very keen to establish a reputation as a strong central bank and therefore wants to ensure that inflation is below, not above, the target for the foreseeable future.

However, part of the answer seems to be that, with no one else performing the role, the Federal Reserve has become de facto the world’s central bank. This is where Asia comes in.

By now, we are all familiar with the series of devaluations, banking collapses and stockmarket crashes experienced in Asia since the summer.

The bubble of very rapid growth, excessive credit and over-investment that was the envy of much of the rest of the world early in the 1990s has been well and truly burst. If the experience of Japan is anything to go by (and unfortunately it probably is) then Asia as a whole will experience much slower demand growth for a number of years.

Late in October, in typical central-banker speak, Greenspan described the impact of the crisis for the US as “non-negligible”. Not only is it right to expect exports to Asia to slow sharply, but imports from Asia will become as much as 30%-40% cheaper as a result of the devaluations, hence prices in the US will come under strong downward pressure.

Is it because of the Asian crisis that Greenspan is prepared to leave interest rates on hold despite strong domestic growth while the UK authorities carry on tightening? The answer is “quite possibly”. But it shouldn’t be.

At first glance, one might think that the impact of the Asian crisis would be bigger for the US. Exports to Asia-Pacific (broadly defined to include Japan, Australia and New Zealand as well as countries which have devalued such as Thailand, Taiwan and Malaysia) account for about 30% of total US exports compared with around half that for the UK. But, because exports are a larger percentage of UK output, exports to the region account for about 3% of GDP in both the UK and US! Moreover, all countries are linked into the destruction of bank capital that is taking place.

So, if Greenspan is right that the impact on the US economy is going to be “non-negligible” there’s a good chance that the same will be true for the UK. And what’s more, in the meantime, UK interest rates have been going up for “domestic reasons”. And much of the impact of Chancellor Brown’s fiscal tightening is going to come through next year.

So, we should expect UK growth to slow sharply in 1998 and inflation might well fall below 2.0%. And don’t forget, if you see George, make sure you tell him that squeezing pips wasn’t a good idea for Denis Healey.

Sean Shepley is a director and head of EU economics-strategy at Credit Suisse First Boston.

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