Commentary: Don't Shackle John Bull

It is now more than two years since British Prime Minister Tony Blair gave the Bank of England authority to set interest rates. That was Blair's way of avoiding the errors that had contributed to high inflation and economic volatility from the 1970s to the early '90s.

Yet now, Britain's central bank may have embarked on a mistaken course all its own. On Jan. 13, it hiked short-term interest rates to 5.75%--the third increase in five months although inflation remains below the bank's 2.5% target.

SPLIT BOARD. Most British economists think a soaring property market and rising wage costs justify these rises. But the bank should be wary of jamming on the brakes too hard. There are many signs that the British economy is going through profound changes similar to those occurring in the U.S. A year ago, many economists predicted that Britain would be in recession in 2000; they now forecast growth of 3% to 3.5%.

At the same time, retail prices of consumer goods are falling for the first time in recorded history--trends that could accelerate with an Internet boom. "The evidence of structural change is quite clear," says David Owen, an economist at Dresdner Kleinwort Benson Securities in London. "The bank is underestimating the impact of the Internet."

Confusion reigns inside the bank. Its nine-member Monetary Policy Committee, which sets rates, is split. A hard-line faction, headed by Deputy Governor Mervyn King, believes that the economy is in danger of overheating. A more dovish group argues that the old trade-offs between growth and inflation may no longer apply.

The bank's New Economy advocate is DeAnne Julius, an American who is one of four independent, or outside, members appointed by Chancellor of the Exchequer Gordon Brown. The other five committee members are bank officials and include the governor, Eddie George. Julius, formerly chief economist for British Airways PLC, warns against "placing too much faith in econometric models of the 1970s and 1980s." She argues that a plethora of changes, from more flexible labor markets to the arrival of discount retailers such as Wal-Mart Stores Inc. to growing use of the Net, are all likely to spur growth in Britain while keeping inflation down.

Julius predicts that business investment, now at a record 14% of gross domestic product, could boost productivity. That would let wages, now rising at a 10-year high of nearly 5%, increase without inflationary effects. The precise impact of economic changes will be hard to measure for a while, Julius says, but the bank could be unnecessarily holding back growth by ignoring them: "The danger on the monetary-policy front is that unless the central bank realizes that the productive capacity of the economy may have increased, then the economy may never reach its new growth potential."

Arguments like these haven't cut much ice with the central bank's inflation fighters. "We should be cautious about those who speak of new paradigms," King said last May. "`Paradigm' is a word used by those who would like to have a new idea but cannot think of one."

BIG FLAP. Internal tensions came into the open last fall when Julius and the three fellow independent members complained about insufficient access to the bank's economic staff. This quarrel, which drew widespread attention, added to the existing impression that the committee, unlike the U.S. Federal Reserve, is unpredictable. "You have two circles with no intersection," says Danny Gabay, an economist at J.P. Morgan Securities Ltd. in London. "If DeAnne is right, Mervyn is wrong." Gabay says that uncertainty about the bank's direction has already driven risk premiums on some sterling contracts to record levels.

Business isn't panicking yet. British rates remain comparable to those in the U.S. And the policy committee, which has moved rates at 15 of its 32 monthly meetings, is likely to cut again if inflation stays down. Still, King and his coterie would be well advised to pay more heed to Julius--regardless of how unconventional they find her views. They don't want to be remembered for having unnecessarily choked off growth by fighting the last war. What Tony Blair giveth, he can taketh away.

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