1998 will see slower growth but, in spite of policy complications, says David Smith, it should be possible for the economy to achieve a smooth landing.
1998 is the year when the economy slows. Or rather, this has to be the year when it slows. If it does not, then before too long base rates will be heading back into double figures and the Clarke/Brown boom will have been added to the catalogue of recent British economic disasters, major and minor. If airline pilots were like economic policy-makers, very few would ever be allowed off the ground. Pilots achieve smooth landings, day in and day out, as a matter of course. We expect nothing less. But getting a sluggish economy airborne is difficult enough, while bringing it back safely down to earth is an infinitely more difficult matter.
And this time, of course, there is an added complication. All economic policy is, to a certain extent, an experiment. The current experiment is with the Bank of England's operational independence. We do not know whether, in its determination to do its job of keeping inflation at 2.5%, the bank will be over-zealous. Still less do we know whether, with monetary policy operated by the bank, and fiscal policy by the chancellor at the Treasury, the right hand will know what the left is doing.
Why its downhill from here
There are four reasons why the economy should slow to something like its trend rate of growth between 2% and 2.5% in 1998, from 3.5%-plus in 1997. The first will be familiar to many readers. Sterling, on average, was more than 15% stronger in 1997 than the previous year. Britain is an open economy in which currency effects are important. This either means that exports will grow at a slower rate, or that the profitability of exports will be sharply squeezed. Both have important knock-on effects on investment and jobs. The pound's 1997 strengthening will be a significant drag - as we have already seen in the survey data on export orders (see above) - on growth in 1998.
Second, interest rates rose in November to their highest level since late 1992, and thus broke out of the narrow range they have occupied since the previous government switched from exchange rate targeting to inflation targeting. Current interest rate levels need to be put into perspective.
In the '80s, the lowest base rate level was 7.5%. Not so long ago, a rise of one-and-half percentage points in interest rate levels, spread over a fairly long period, would have been regarded as a mere gnat's bite. Things are different now. The rise has occurred even as inflation has remained low.
Real interest rates have therefore risen significantly and this can be expected to dampen the economy further.
Third, the business cycle will - sooner or later - exert itself. A recovery that began in the spring of 1992 is already a mature one, although this one has been unusual in that it has had twin peaks in growth. Of the twin peaks, the first, in 1994, was mainly due to exports, while the other, in 1997, was explained by the strength of consumer spending. Twin peaks are unusual, but the cycle has not been broken. If anything, they have made it more likely that 1998 and 1999 will see a cyclical downturn.
Clouds brewing in the east
Fourth, growth prospects in Asia for 1998 are less than healthy. A significant slowdown is on the cards for at least some Asian economies. In the case of Japan, economic activity has struggled to build up steam throughout the '90s and the much-publicised problems in the Asian tiger economies are another worrying factor. The knock-on effects of the Asian slowdown will impact directly on America.
The death of the current US recovery has been slow in arriving - just when it looks as if it is time to read the last rites, up pops a new set of numbers showing a buoyant economy and a healthy jobs market. But America, even more so than in Britain, is in a very mature phase of the cycle, and overdue for a slowdown. It will surely occur in 1998. If the US business cycle suffers a downturn, Britain's will follow.
The dismal science again
So if a slowdown is highly likely in Britain, how sharp will it be? Economists always sound so dismal when they talk about the desirability of a lower rate of economic growth. In the case of the UK economy, the argument is largely based on the claim that the slack in the economy has been more or less used up, the evidence of which is seen in rising skill shortages.
If there is no easing in the pace of growth, these pressures will increase, culminating in higher inflation. This can be disputed. If you take an optimistic view of the supply-side changes that have occurred in the economy in recent years, the official estimate of trend growth in the economy of only 2.25% a year looks cautious. It is not hard to make a case for 2.5%, or even 2.75%, and this makes a big difference to assessments of the amount of slack in the economy. The trouble is, it matters not whether you or I think the economy's underlying growth is more than 2.25% a year, as long as policy-makers base policy, and interest rate changes, on such a cautious assessment.
The four factors I have described should be enough to slow the economy to something like the trend rate this year. On the upside, the appetite of British consumers to carry on spending is a decisive factor. On the downside, the risk is of overkill by the operationally independent bank, combined with a pronounced world downturn led by Asia. As always, achieving a soft landing with precision will be the challenge.