Sunday, October 05, 2008
Time for a big, bold cut in interest rates
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Writing about the economy these days is a bit like being in an HG Wells novel. Everything is compressed in time. The speed of events is dizzying. We are in an economic time machine.

I wrote here on the last day of August that the case for delaying a cut in Bank rate come October could be looking very thin. Then we had a series of speeches from the Bank of England's decision-makers showing they were aware of the downside risks but were in no mood to rush things.

Now October has come and the debate is not about whether the Bank's monetary policy committee (MPC) should cut this week but by how much. The economic data have been poor, particularly the purchasing managers' surveys that provide the best snap assessment of output growth.

Official figures show the service sector has ground to a halt, with no growth in the three months to July, and only business and finance showing expansion of the five components of the index. Even that cannot last, as a sharp drop in the purchasing managers' index for services in September showed. Marks & Spencer and John Lewis, bellwethers both, are seeing sales drop.

More importantly, and this is why time has become such a factor, the disarray in the credit and money markets that swept in last month means pressure is intense on the Bank to do something, anything, to try to alleviate the danger.

That is certainly the view of the "shadow" MPC, which meets under the auspices of the Institute of Economic Affairs. Members of the shadow committee have seen a few crises and recessions in their time. They are, to borrow from the current debate between the political parties, anything but novices.

Their latest deliberations, in anticipation of this Thursday's decision by the actual MPC, show that they have come within a whisker of urging the Bank to wheel out the big gun and cut by half a point to 4.5%. Four of the shadows, Ruth Lea, Gordon Pepper, Patrick Minford and Peter Warburton, vote for this move.

Three others, Tim Congdon, John Greenwood and Kent Matthews, say the Bank should stick to its normal size of rate change and just cut by a quarter point. The two remaining members, David B Smith and Peter Spencer, opt for no change.

The four "half-pointers" make a good case of it. Lea says recession has taken over from inflation as the main risk facing the economy and that events in the financial markets which "defy hyperbole" require a radical response.

Pepper, a veteran monetarist economist who influenced Margaret Thatcher, is alarmed by a collapse in the growth of the money supply and powerful evidence of debt deflation. He admits to considering an immediate full-point rate cut, followed by two quick half-point reductions.

Minford, who has called for aggressive rate cuts for some time, sees this as the last chance to avoid a sharp recession in Britain in 2009. Warburton says the credit system has "atrophied" and also believes the deep downside risks he has been warning of for some time are now in plain view. Their full contributions, as well as those of the other members, can be read on my website (

What will the Bank do? Though a head of steam has built up, these things are never a done deal. Not until the Bank's governor, Mervyn King, calls for a vote on Thursday morning can we be sure of the outcome.

There will be voices arguing for delay on presentational grounds. On October 14, just a few days after this week's vote, September inflation figures will be published and are expected to show the rate rising to a high of 5%. The Bank will have that information this week and most MPC members would have preferred to wait until after inflation has peaked before cutting again.

There is also the possibility the Bank will, in what would be a searing admission, own up to its own impotence, acknowledging that a cut in rates might not do anything. Keynes identified the circumstances in the 1930s when cutting rates would be like pushing on a piece of string. Or to use a seasonal analogy, sweeping up leaves only to have them blown back in your face.

Some would say that for the Bank to cut at this juncture would be the equivalent of politicians desperate to show they are doing something: "Now is the time for a really stupid and futile gesture."

There is no doubt that the days when a deft touch on the tiller by the Bank of England sent powerful shockwaves through the economy are long gone.

The extreme weakness of mortgage lending, with virtually no net increase in August, shows how the capacity of the system to lend has been severely curtailed, even before September's financial storms.

The Bank's own credit-conditions survey, out last week, confirmed that banks had cut back aggressively on credit provision and expected to continue to do so. A shortage of funding, newly cautious lending policies and a drop in credit demand from recession-spooked borrowers are all contributing to a slump in the supply of credit into the economy. Money-market strains have been intense, pushing three-month Libor closer to 7% than 5%.

To me, this argues for more activism on policy, not less. The fact that the avenues through which monetary policy operates are clogged means that the Bank will have to turn on the siren to get through.

So this is a time not for futile gestures but bold ones. I'll repeat what I said a couple of weeks ago and say I would cut by half a point this week. Many others now agree. Whether the Bank does so, we shall see.

PS An unusually large number of readers responded to last week's column, pointing out that this "bust" was not preceded by a strong economic boom. The confusion arose, I think, because most people find it hard to distinguish an economic or spending boom from a boom in asset prices, in Britain's case, housing.

It should not be a difficult distinction. Other readers seem to think the consumer-spending numbers I quoted less than 2.5% a year growth over the past five years must exclude expenditure on housing. Not so, of course.

The picture many have, of consumers borrowing to indulge in a spending binge, is wrong. The vast bulk of borrowing has been long-term, to buy houses, rather than for consumption. Even housing-equity withdrawal, which figures on Friday showed has gone negative, is misunderstood. Bank estimates show that three-quarters is due to older people selling up and saving the proceeds.

The other misunderstanding is over the switch in the inflation target from RPIX (the retail-prices index excluding mortgage-interest payments) to CPI (the consumer-prices index) in late 2003. The former includes house prices, the latter does not. I did not agree with that switch, done as a sop to Europe, and neither did the Bank. It undermined trust and, as we have seen, generates conspiracy theories.

Perhaps because the Bank did not like it there is evidence it ignored the switch for a while. It raised rates five times in 2003-4, though CPI inflation was well below the 2% target. RPIX inflation, however, was at times above target over that period, justifying hikes. The infamous rate cut in August 2005 came when RPIX inflation dropped below target but CPI was above it.

There is a debate about whether the MPC should have taken asset prices more into account in setting rates, though Steve Nickell, an MPC member then, argued it would have taken much higher rates recessionary rates to have done the trick. The idea that the Bank was fooled into inaction by the target switch is, however, a myth.

From The Sunday Times, October 5 2008