Will Britain Have To Hit The Brakes?

There comes a time in every recovery when interest rates have to rise. In Britain, that point is still a ways off, but it's now close enough to worry the financial markets, especially given the latest signs of a solid recovery--and hints from monetary officials that they'll strike at inflation preemptively.

Despite the 9 billion in new taxes introduced in April, real gross domestic product grew at an annual rate of 3.6% in the second quarter, while nonoil GDP rose at a 3.2% clip (chart). The gains were broad, with manufacturing output up strongly, fueled by higher exports, especially to countries outside the European Union. Construction also posted a solid gain, as did the service industries. Both total and nonoil GDP now have surpassed their prerecession highs, and 1994 growth will likely exceed the government's 23/4% forecast.

The impact of the tax hikes may yet show up in the second half, but so far there is little hint. In fact, according to the Confederation of British Industry's July survey of industrial trends, manufacturers say orders are rising at the fastest pace in nearly six years, with further steady growth expected through November.

Before the GDP report, monetary authorities had already warned that, if the recovery quickened, an early hike in interest rates could help to sustain the expansion. And after the data were released, Chancellor of the Exchequer Kenneth Clarke said he intended to make sure the upturn did not turn into a "boom which goes bust." As a result, the summer rally in stocks cooled off on July 25, as the markets began to speculate about higher rates.

A slowdown would have its pluses, especially in the financial markets, since the economy cannot keep growing at its current pace without eventually generating capacity bottlenecks and potential pressures on wages and prices.

Right now, Britain enjoys the best of all worlds: the fastest growth in more than five years, falling unemployment, and the lowest inflation in a quarter-century. The inflation outlook's best feature is a new flexibility in the labor markets. Despite the 18-month drop in the jobless rate, pay settlements remain very moderate, and productivity gains have been good. But if the economy continues to barrel ahead, a rate hike before yearend is not out of the question.

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