Although Chancellor of the Exchequer Gordon Brown's move to make the Bank of England independent does not break new ground globally, it has created a new environment in the UK.
The group approach, with a panel of four from the Treasury and four from the Bank controlling interest rates to achieve inflation targets prescribed by the government, raises the issue of how the team will decide what is the appropriate level of interest rates for any given point in the economic cycle.
There are a number of ways in which the adequate interest rate level can be calculated. We use the concept of the output gap, defined as the difference between actual and potential output of an economy. The graph illustrates this approach. The wave represents the cycle of GDP growth around a country's long-term potential growth rate. At points above the horizontal line, such as A, actual output is above potential output and hence there is a positive output gap. The traditional model states that at points such as A when the economy is growing too fast for its own good, inflation will be rising and so should interest rates.
To estimate the correct interest rate level we use Taylor's Rule (first cited to explain the Fed Funds Rate in the US but, according to our research, equally applicable to this case). Taylor's Rule relates the output gap to interest rates to say, given past experience, what interest rate is required to counter inflationary pressures at this point in the economic cycle. As you would imagine this is especially important for central banks who, according to Alan Greenspan, should always pursue a neutral monetary policy.
Our next step is to factor the drive for efficiency and the tendency towards globalisation into the model. Growth need not automatically lead to inflation as long as it counterbalanced by increased productivity. The modern mobility of capital is an illustration of both of these points, with the relocation of production to low cost areas and the move towards shorter term contracts becoming ever more commonplace in all industries. These factors allow productivity to be increased, which releases inflationary pressure, effectively breaking the simplistic link between growth and inflation. We factor productivity increases into our calculations to take account of the globalisation effect. Our model has been extended to provide calculations for long term interest rates too, meaning that we have an econometric method for bond yields and short rates.
Applying the model to the real world we find that, in the US, further interest rate rises are not strictly necessary, since the strong GDP growth is being countered by continuing productivity gains. Our calculations show that equilibrium interest rates for the US stand at about 5.75% (ie broadly where they are now) with a figure of around 6.75% to 7% on the long bond.
In the UK, our interest rates look a little too low using traditional analysis. Factoring in sterling's 20% appreciation this year, however, current rates look about adequate for the current point in the cycle. The Bank of England's well-known Four to One Rule" means that the UK has endured the equivalent of rate rises totalling 5% from its currency alone and this has stopped the strong consumption feeding through to price increases on the High Street. House prices, while increasing markedly in some areas, are not running riot across the nation. Similarly, wage increases, where seen, are being limited to those areas where skill shortages exist.
Thus, the equation linking GDP growth to inflation is not as robust as once it was, in either the UK or the US but, whichever model the respective banks are using to calculate equilibrium interest rates, they both seem to be getting it broadly right at present.
Stewart Cowley is head of global fixed interest at Hill Samuel Asset Management in London"