Sunday, January 27, 2008
Bank should cut, but not panic
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

This is a longer version of the piece that appears in the Sunday Times, and with a headline that better reflects the theme.

Who would be a central banker? The salary isn’t great by City slicker standards; the pension is pretty good, though probably not good enough to compensate for the ordure rained down on you while in office.

So Ben Bernanke, Mervyn King’s old office neighbour when they were both academics, has been attacked for panicking in response to the global stock-market sell-off and for allowing Wall Street to dictate the Federal Reserve’s monetary policy.

People have different views on this – I happen to think the action was right, following the Fed chairman’s gloomier assessment of America’s economic prospects even before Blackish Monday. But the execution of the three-quarter-point cut, the biggest since 1982, was clumsy.

Here, King has finally got what he did not wish for but has long predicted. After five years of independence he warned that the challenges for the Bank were likely to get much tougher. After 10 years, and his first open letter to the chancellor explaining why inflation had gone too much above target, he repeated that warning. He was more right the second time.

What are we to make of the governor’s admission last week that the Bank has “little control over the strength of the economic winds buffeting our economy” and that those winds are likely to continue blowing through 2008?

Does the fact that King is open to the possibility that he may have to write another letter to the chancellor mean that interest-rate cuts are off the agenda? After all, the monetary policy committee (MPC) voted 8-1 this month to leave Bank rate on hold at 5.5%.

The answer, I think, reading between the lines of both King's speech in Bristol and one by Sir John Gieve, joint deputy governor, a few days earlier, is that this was not the message. When, in April last year, that first open letter was written, the Bank was widely attacked for falling down on the job. There is no doubt that this was a scarring experience that contributed to a mood of hawkishness on the MPC.

So the Bank is getting its excuses in first, recognising that there are upward pressures on inflation but attributing them to global developments. These are precisely the circumstances where, according to its independence remit, it can allow inflation to run above target for a period.

The remit says: “The framework takes into account the fact that any economy at some point can suffer from external events or temporary difficulties, often beyond its control. The framework is based on the recognition that the actual inflation rate will on occasions depart from its target.”

Trying to keep inflation at 2% now would squeeze the economy too hard at a time when, according to King, a 5.5% Bank rate is already “probably bearing down on demand”. So there will be rate cuts, and they will be the right thing to do, despite the inevitable chorus there will be from the hair-shirt brigade. They should start with a quarter-point early next month.

Slower global growth, and slower growth in Britain, will mean the rise in inflation is temporary. It is too early to put out the flags but global economic worries mean oil's sojourn above $100 a barrel did not last, though it needs to fall $30-40, not just $10-15. Whether it will with markets as capricious as they have been recently remains to be seen.

How low should UK rates go? My start-of-year prediction was 4.75% this year and I am inclined to stick to that. King distanced himself from Bernanke-style dramatic gestures but plainly did not rule out lower rates, though if does have to write a letter or two (I think he probably won't), he will need all his literary skills.

The hardest thing for the Bank is not whether it should cut rates, but how to justify doing so to people not familiar with the remit or with the forces of slowdown and temporary inflation it is trying to balance.

But though it will be hard, particularly when you have to get past the hair-shirters, it is not as difficult as it looks. Most people know instinctively that many retailers are cutting prices and that petrol-price rises reflect international developments. The end of house-price inflation also makes life easier; there is no doubt that higher mortgage costs have pushed up the public's expectations of inflation.

So the situation is challenging but manageable. And if King is right that at the end of it we will have an economy with higher savings and less dependency on the consumer, nobody – perhaps apart from the retailers – will complain too much.

Finally, what should we make of the warning from George Soros, courtesy of the BBC's Today programme, that both the US and UK companies are heading into recession? Not a lot. The man who brought down the pound in 1992 has a habit of popping up like the ghost at the feast. His recent contributions to the economic and financial debate have not, however, been noteworthy, clouded as they have been by his yearning to see George W Bush out of the White House.

Predicting a US recession has become almost de rigeur, as we have seen in recent days in Davos, although even there the debate has been dominated by the serial gloomsters. Britain, however, is a long way from recession, growth in the fourth quarter being 0.6%, close to trend.

A big slowdown will occur, and it will be touch and go whether this is the weakest year since 1992, as well as the most challenging for the Bank since independence in 1997. But it need not be more serious than that. Provided, of course, that King and his colleagues show intelligence and flexibility.

From The Sunday Times, January 27 2008


Maybe they could justify it with the truth - that falling credit demand means they would need to remove lots of liquidity from the banking system to keep rates at a high target, and they cannot do this as it would cause too much stress in certain banking institutions? That, after all, is precisely the reason the Fed was forced into the emergency 75bps cut a few days ago.

Posted by: Minh at January 27, 2008 02:09 AM

David, I broadly agree with what you're saying. I just want to make a few points.

Concerning the issue of global forces affecting the UK inflation rate. I fully agree that policy should be set to meet the 2% target over the 2-year horizon. But on this occasion, there are two other factors to consider. First, cutting interest rates while inflation is heading towards the 3% target could give the impression that the MPC targets growth, not inflation. This could be dangerous when there is already uncertainty about the level of inflation expectations.

Second, the exchange rate. The pound has already fallen sharply and the rebalancing process that Merv spoke of is likely to involve further falls. This will intensify the impact of global price pressures. For example, the UK isn't likely to benefit entirely from the recent drop in the oil price. So to some extent, the trade-off between growth and inflation could deteriorate for a period.

This is all about how the Bank responds to demand and supply shocks. There has been an obvious demand shock (the credit problems), but also supply shocks (the fall in the pound, the rise in energy prices and other globally-traded goods). The Bank needs to ensure it responds consistently to these. In 2003, the Bank cut interest rates because it was concerned about disinflation/deflation (the positive supply shock coming from Asia). These concerns outweighed the strength of consumer spending and the housing market (a demand shock).

I’m not suggesting the MPC shouldn’t cut interest rates. As you point out, rates are still in ‘restrictive’ territory. But policy might have to remain slightly tighter than would otherwise have been the case. The Bank should also be cautious about how quickly it cuts.

Posted by: Sell Everything at January 27, 2008 10:47 AM

I get a bit fed up with people "reading between the lines" and then drawing a bunch facts from it that purport to be fact. And I quote from your column
"5.5% Bank rate is already “probably bearing down on demand”. So there will be rate cuts,"
Well if you raise interest rates then its purpose is to bear down on demand, maybe Merv was merely commenting that that the medicine was having the desired effect ! although the first word is probably.........
So you have drawn a conclusion that interest rates must rise on the basis of a comment the can be interpreted in many various ways and which the originator only posed as a question.
Really very sloppy thinking !!!

Posted by: Bryan C at January 27, 2008 09:48 PM

And I'm getting a bit fed up of your tedious and sloppy comments. I think you mean "fall" when you write "rise", and you clearly don't know the way these things work. A central banker never says: "I'm going to cut interest rates next month". Our job is to try and interpret what they say - which is always somewhat oblique - and, indeed, to read between the lines.

Posted by: David Smith at January 28, 2008 08:54 AM

Dear David,

Correct I did mean fall and not rise. And strangely enough I do know how these things work indeed central bankers are deliberately Delphic and one of the reasons they are is because they don’t set interest rates, they only have one vote (and an unknown degree of influence on the other member of the committee) in our the MPC set up one vote of nine.
And I am sorry if my comment came across as rude it wasn’t meant to be, but I stand by it. One rather ambiguous comment by a central banker, who is one ninth of the franchise, and who wasn’t certain of the comment himself hence the word “probably” is not compelling evidence of falling interest rates. And it is important because you base the rest of your column on that fact
Bryan C

Posted by: Bryan C at January 28, 2008 12:46 PM


I have been searching and am yet to find a succinct definition for 'hair shirter' the best guess from what I've found is some reference to hair shirts worn by medieval monks, that were purposely uncomfortable in some strange form of self flagellation. I am wondering what the link is between this behaviour and attitudes to interest rates?

Posted by: OldFashionedBanker at January 28, 2008 02:20 PM

Still tedious Bryan C, not least because the column was not based purely on a reading of Mervyn King's speech. As for Old Fashioned Banker, I'm sure you know what I mean by hair-shirters.

Posted by: David Smith at January 28, 2008 03:24 PM
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