Sunday, December 02, 2007
Time for a rate cut gift from the Bank
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


December is not normally a month when the Bank of England sets the world alight. Only once in 10 years of independence has it changed interest rates in the run-up to Christmas.

It would be wrong to say members of the monetary policy committee (MPC) are too busy carousing at this time of year to think about altering rates but something stays their hand. Will this December - this Thursday - be any different?

One straw in the wind is that the only December cut was when world financial markets were gripped by crisis, in 1998 when the Asian, Russian and Long Term Capital Management hedge fund crises came together. The credit crisis that exploded on to the scene this August is still with us and has further to run.

Not only that but a sudden shift of opinion has occurred on the “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs. The shadow committee is not given to wild swings.

Last month it voted unanimously to leave Bank rate unchanged at 5.75%, arguing there was insufficient evidence of a credit crisis impact on the economy. This month, five of its members vote to cut, and not just by a quarter of a point.

Thus, Tim Congdon of the London School of Economics, emphasising the need for the Bank to restore normality in the banking system, says there should be a half-point cut.

He is joined by Peter Spencer of the Ernst & Young Item club, who is particularly concerned about the rise in Libor (the London interbank offered rate), back above 6.5% last week, and its impact on small and medium-sized firms.

The third half-pointer is Peter Warburton of Economic Perspectives, who is concerned about Britain’s exposure to the global credit squeeze, and thinks the Bank will have to cut to 4.5% during 2008.

Even these three are outdone by Patrick Minford of the Cardiff Business School. “It is time for some sense to prevail,” he says. “Rates need to be cut by 75 basis points at once to stabilise a fast-deteriorating situation.”

Strong stuff. The four are buttressed by John Greenwood of Invesco Asset Management, who opts for a quarter-point cut at this stage but notes that the credit “crunch” (there’s still a debate about whether this is a crisis, squeeze or crunch) has dramatically changed the UK outlook.

What about the four non-cutters? Two, Ruth Lea of Arbuthnot and Trevor Williams of Lloyds-TSB, have a “bias to ease”, meaning they will be ready to reduce rates but not quite yet. Andrew Lilico of Europe Economics, is neutral. My near namesake David B.Smith, thinks Bank rate may yet have to move higher. It is a broad church, the shadow MPC.

It is not be ignored and has a good record of predicting decisions of the actual MPC. What have we been hearing from the real thing? Two members, David “Danny” Blanchflower and Sir John Gieve, a deputy governor, are already in the rate-cutting camp.

Their view is that if Bank rate is to fall, as last month’s inflation report signalled, why hang about? They also think 5.75% is above the “neutral” rate, and implies policy is restrictive.

Gieve, with his responsibities for financial stability. is closer to the credit crisis than most MPC members. Blanchflower, who spends half his month at Dartmouth College, New Hampshire, is closer to the US economy. Goldman Sachs now sees a 40% to 45% probability of a stateside recession.

Of the others we have heard from in recent days, Mervyn King, Charlie Bean, chief economist, Rachel Lomax, the other deputy governor, it has been hard to detect anything that hints at an imminent cut. Tim Besley and Andrew Sentance, the MPC’s uber hawks, appear unbending.

Sentance said in a speech that the Bank was having to cope with two “shocks”; the downward impact of the credit crisis on growth prospects and the upward impact of higher oil and food prices on inflation. Oil prices have retreated a bit but not enough to resolve his or the Bank’s dilemma.

Lomax also put a bit of a dampener on things on a visit to Hull - a place that would benefit from cheering up - when she said the rate cuts implied in the Bank’s inflation report last month were “projections not promises”.

MPC members are good at playing their cards close to their chests. We have not heard from Paul Tucker or Kate Barker, who could be ready to cut. But the position, as things stand, is that none of the seven members who voted to hold Bank rate at 5.75% last month have even hinted they are ready to join the two cutters. This week’s decision will go the wire.

What should the Bank do? I have been cautious about calling for rate cuts in the wake of the credit crisis, for two reasons. One was the possibility, though perhaps not the likelihood, that the crisis would pass quickly. The other was lack of firm information on the impact of the crisis on the economy.

The first objection is fading. If we take three-month Libor as a guide, between early October and mid-November it hovered within half a point of Bank rate - not normal but not painfully high either. Now, it appears to be heading back to a percentage point above Bank rate.

Some of this reflects the end-year scramble for liquidity by the banks, which the Bank is trying to address, but it is also a reflection of the wider credit malaise. As long as Libor is at elevated levels, the Bank is presiding over an additional tightening of monetary policy it did not intend and the economy does not need.

On the second point, evidence is starting to accumulate of an economic effect. Growth was revised lower in the third quarter and business investment was flat. Consumer and business confidence are weak. Housing market activity has tailed off sharply, with prices down 0.8% last month according to the Nationwide (though after a 1.1% rise in October) and mortgage approvals at their lowest for nearly three years.

The Bank has to be forward-looking. If growth slows sharply, inflationary pressures will ease. That is why the time has come for the MPC to start reversing some of this year’s rate hikes. I opposed the quarter-point hike from 5.5% to 5.75% in July so let me start by calling, not for half or three-quarters like some members of the shadow MPC, but just a quarter-point cut.

Will it happen? Only members of the MPC know, and some of them have not yet made up their minds. Despite Lomax’s caution, rates are coming down. The only question is one of timing.

PS Scottish devolution has brought out a lot of strangeness. The other day I was watching an edition of BBC Question Time from north of the border - I know I shouldn’t - and several panellists were claiming it is nonsense to say Scotland gets more than its fair share of public money because government spending per head is higher in London.

How on earth did they get to this number? By allocating all of the headquarters spending located in Whitehall and other parts of London to the capital, in the same way that applied to Scotland you would get a very big number for Edinburgh. Properly measured, spending on services per head last year in Scotland was £8,414, 3% above the London figure and 21% higher than the average for England.

I mention this because it is time to award the prizes in my Freakonomics contest - films with real-life consequences. Jennifer Haynes suggests devolution would not have happened if Hollywood hadn’t fired up nationalist fervour with Rob Roy and Braveheart. Scots may disagree but it is too good a suggestion not to be true.

This is also the case for my second prizewinner, Jeremy Kent-Baguley, who says there was an increase in marriage rates in America, and a decline in infidelity, after the film Fatal Attraction. Nobody, it seemed, wanted to risk getting on the wrong side of a potential bunny boiler. Thanks for all suggestions.

From The Sunday Times, December 2 2007


A rate cut is a good idea so long as it doesn't re-inflate the UK housing bubble.

House prices do need to fall by (as HSBC chief economist says) approx 30% in order to return the living standard of the average working person in the UK to some kind of historical norm.

Posted by: Nick thorne at December 2, 2007 08:33 AM

Two things demonstrate the credit crunch is a lot worse than previously expected:

The action on the ABX during Oct/Nov showed that the credit crunch was only going to get worse.

The E-Trade mark at less than 30% of par for their prime money-purchase first charge mortgages (not HELOCs as some have said) is the only real trade in RMBS recently. A 70% loss is quite impressive.

Posted by: Minh at December 2, 2007 10:13 AM

Actually, with a bit of further poking around it seems the E-Trade asset sale established a mark of 11 cents on the dollar (89% haircut) and was backed by about 70% prime first-charge mortgages:

Posted by: Minh at December 2, 2007 10:26 AM

Thanks for that detail. On HSBC, two things. One is the simple mathematical point: if houses are 30% overvalued it requires a 23% fall to bring them back to fair value. Second, what HSBC said was slightly different - that there was 30% of the price rise it could not explain with its model. I have some problems with its analysis but I won't go into them unless HSBC wants to make the report available for everybody to see.

Posted by: David Smith at December 2, 2007 11:01 AM

A. Sentance spoke gave us third year economists at warwick uni (where he is based part-time) a lecture recently, and he appeared to be fully undecided, although central bankers will be central bankers. I think the drop in oil price, reducing upward inflationary pressures, will help lubricate a rate cut: and bringing it forward to pre-2008 may help confidence a little.

On another note, 75 basis points?! Is Mr Minford getting bored of stable price expectations? There can be no doubt that one of the banks best achievements since independence has been anchoring expectations tightly around target. Steady-does-it please Mervyn.

Posted by: Mark S at December 2, 2007 01:39 PM

Here is an interesting link that looks at the other side of the coin.

Posted by: dan at December 2, 2007 01:44 PM

I suspect that agflation will prevent a quick rate cut - assuming that the MPC are aware of a rather unsettling new development: fertilizer shortages - I have just received warning notices from suppliers.

Posted by: Mr Naresh Radson at December 2, 2007 03:22 PM

Not sure about 'interesting' link Dan, I think terrifying is probably a better word for any suggestion that the next move in rates might be up. I would be inclined to stock up on canned goods and lock myself in with a shotgun if it were. The Bank clearly, and wrongly, wants to see dead bodies floating to the surface before it takes the already long overdue step of cutting rates. But what do I care? By sitting on their hands and umming and erring, the cuts will need to be much deeper when they do come, but for many it will be too little too late.

Posted by: Matti at December 2, 2007 03:51 PM

Dog doesn't eat dog but I have to agree with that.

Posted by: David Smith at December 2, 2007 03:58 PM

Everytime rates are cut, it doesn't seem the money goes anywhere other then in to property, we're seeing unsecured lending under control, it's secured lending thats the problem here, and with only one blunt tool to control the cost of money, it's little surprise.

It's almost as if we could do with one set of rates for borrowing against assets and one to support 'other things' - I know it's pie in the sky thinking, but cutting rates will just send a further sign to property speculators, and we're in this mess because of them.

Feeling the pinch at 5.75% is a bad, bad sign that things with this economy have got way way out of its depth and with borrowing costs still at "historic lows" it begs the question, when inflation is so prominent, just where do we go from here?

Posted by: Dan at December 2, 2007 04:17 PM

A rate cut?. You are joking aren't you Mr smith?. If the BOE cuts rates, i see the following outcomes:

1. Absolutely no guarantee that banks will pass this reduction on, either through lower mortgage rates or loans.

2. A large rise in inflation, due to a drop in sterling. Seeing as the UK imports such large amounts of goods & services these days (due to labour's wonderful incentives for businesses to remain in this country), this is almost guaranteed.

The MPC are stuck between a rock & a hard place. The sensible thing to do is to keep rates on hold.

Posted by: matthew at December 2, 2007 05:17 PM

Dan, I think you're right - we certainly need some way of ensuring it doesn't all just go into housing - unproductive investment at best IMO. Why not encourage people to invest their spare cash into local businesses that actually produce something instead? Mervyn has already said he wishes house prices were part of his remit, or a bigger part than they currently are.

As for the fall in the oil price, which fall would this be - from $98 to $94? A fall of $4 when the price is still far higher than this time last year doesn't make a rate cut any more likely for me.

Posted by: Minh at December 2, 2007 06:24 PM

On its own, a 5.75% Bank rate was slowing the economy, though only gradually. The additional factor is, of course, the credit crisis, which has raised the cost and limited the availability of credit. The argument for action by the Bank rests mainly on that - by cutting Bank rate the hope would be that not only overnight rates but three-month Libor would come down by a similar amount. The latter, I'd accept, is far from guaranteed.

For information, the oil price was $88 on Friday, though it could easily go up again, particularly if Opec takes a hard line on output this week.

Posted by: David Smith at December 2, 2007 07:45 PM

Dear David,
As you mentioned, the key-point here is the relationship between the three-month Libor and the bank rate.
Statistical regressions using historical data confirm that by cutting the Bank rate, the three-month Libor comes down by a similar amount. However, in periods of increasing uncertainty,
the one-by-one relationship breaks down and the three-month Libor either go down by less, or resists.
Noting also that in the current uncertain environment it would (in my view) make sense for the MPC not to change the Bank rate (to avoid a decision which they might regret at a later stage), I would conclude that they should not cut yet.
Many thanks.

Posted by: C Milas at December 3, 2007 10:00 AM

Merv said it's not a matter of timing, it's a matter of data.

After todays figures they have to cut rates IMO or they will look more follish than they already do. I think the only question over tomorrow's decision is not if, it's by how much. I believe they will and should do 50, if they don't move at all there will chaos, confusion and heads will roll...

Posted by: James Trouble at December 5, 2007 10:29 AM
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