Sunday, November 09, 2008
No time for wimps as the history boys take over
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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In recent years, when talking to younger audiences, I used to express mock wonderment that we had all become so obsessed with small changes in interest rates. This was when quarter-point changes were the norm for the Bank of England's monetary policy committee (MPC).

A quarter-point change, I suggested, would have been for wimps in the old days, when there was a lot more red meat in the policy diet. "Up by two points, down by one" was not what always happened but it was by no means unusual.

There were good reasons why there was a shift to much smaller rate changes. The general level of rates came down compared with the 1970s and 1980s, when the Bank rate was often in the mid-teens. The economy was sensitive, it seemed, to even small rate moves. The MPC's approach was incremental; monthly meetings meant small changes would cumulatively turn into larger ones quite quickly.

So where did Thursday's wimp-busting 1.5-point shocker come from? First, as I have been arguing for some time, rate cuts lost their potency because the normal transmission mechanism from Threadneedle Street to Main Street is not working. The Bank has to cut more aggressively now to get the same effect as it did two years ago.

Second, the Bank had some serious catching up to do. To wait from April until last month before cutting rates even as the economy was deteriorating fast was the equivalent of being asleep at the wheel.

Third, recent economic news has been dire. The Halifax's report of a 2.2% drop
in house prices last month dashed hopes that the pace of decline was slowing. Figures from the Society of Motor Manufacturers and Traders showed a 23% fall over 12 months in new car registrations. The home front is weak, with the Bank's own agents reporting a "continued severe contraction in the near term".

So is the global economy. The International Monetary Fund lopped a point off its 2009 global growth projection in the run-up to last month's annual meetings in Washington. Now it has taken off a further 0.75 points. The world economy will grow just 2.2% next year, it thinks, all concentrated in the emerging world. The advanced countries will decline together for the first time since the second world war and the UK economy will shrink by 1.3%. Desperate times, desperate measures.

How low will Bank rate go? That depends on how bad members of the MPC think things are. After all, Mervyn King, the Bank governor, has spoken of the banking system being closer to collapse last month than at any time since the start of the first world war and his colleague Danny Blanchflower seemed to agree, suggesting the credit crunch "may turn out to be more significant than the 1929 crash".

Charlie Bean, the Bank's deputy governor, trumped them both in an interview with the Scarborough Evening News, saying we were in "possibly the largest financial crisis of its kind in human history". They are hard to please in Yorkshire; his remarks did not make the front page.

Fantastic copy though all this is for journalists, there is a danger we might suffer from a degree of time distortion, where current events are magnified in their importance compared with those in the past.

Peter Dixon, an economist at Commerzbank, has examined the "worst in human history" claim. For the stock market, the fall from levels immediately before the credit crisis to last month's lows, 43%, is not even the biggest this century in the early 2000s there was a drop of 52%.

Although forecasts are changing all the time, most economists are looking for a recession lasting four to five quarters, in line with the post-1970 UK average, and a peak-to-trough fall in gross domestic product of 2% or so, less than the recent average of 3.4% and modest in comparison with the early-1980s slide of 6.1%.

To be fair to the Bank trio, it is possible to talk of a financial crisis of enormous magnitude while also taking action to head off its worst effects on the real economy. The Bank's new economic forecast, to be published this week, will predict recession after the rate cut we are all wondering how deep but not a 1930s-style slump.

The fact there will be a significant recession is testimony to the downward pressure on the economy. The Bank's own economic model would suggest that in normal times big rate cuts and a lower pound would produce a rapid return to growth.

For those who like historical numbers, by the way, the 1930s has probably been unfairly characterised as the grimmest ever. The economy contracted 0.7% in 1930 and 5.1% in 1931 before recovering in 1932. But immediately after the first world war was worse, with declines of 10.9% in 1919, 6% in 1920 and 8.1% in 1921. No wonder people welcomed the Roaring Twenties.

Everybody knows by now that we have not had an interest rate lower than 2% since 1694. There was thought to be a minimum level of rates necessary for anybody to forgo the benefit of having cash now.

Now, of course, that 2% low may well be challenged. It would only take another move like last Thursday's, or more likely three smaller ones, to get there. The key to it is the real interest rate.

Before the dramatic cuts of the past few weeks, the MPC's modus operandi was that it was essential not to let real interest rates the interest rate less inflation turn negative, or at least not decisively so. That, according to some MPC members, led to the inflationary errors of the 1970s.

So even when it expected a sharp fall in inflation, the MPC was not prepared to let Bank rate, 5% as recently as last month, move too far away from current inflation, also close to 5%. That has changed. It is now prepared to run a negative real rate, a 3% Bank rate against a 5.2% inflation rate, at least on a backward-looking basis. It is confident of a very big fall in inflation and recognises the need for an unusual stimulus. If inflation is on course to drop to 1% or below, even a 3% Bank rate is high.

Last time consumer price inflation was close to zero, in the middle of 2000, Bank rate was 6%. This time interest rates will follow inflation down. We will, I think, see an interest rate beginning with a "1". Anything else would be for wimps.

PS: The emphasis leading up to Alistair Darling's pre-budget report has been on using public spending to cushion the blow of recession. Now talk is turning to tax and there is scope for some fine-tuning to make life easier for business.

At Ernst & Young, head of tax policy Chris Sanger is a former adviser to Gordon Brown. He and Patrick Stevens, a partner, have a number of suggestions, including extending firms' right to "carry back" losses for three years, as in 1997, rather than the present one year. Profitable firms, slipping temporarily into loss, would thus benefit from a tax rebate.

Changing the timing of corporation- tax payments would also help. They suggest firms pay 10% of their bill each quarter rather than 25%, with a lump sum for the remainder due after the end of the tax year. Similarly, smaller firms would benefit from a switch from monthly to quarterly Vat payments.

Bolder ideas include a holiday from employers' National Insurance contributions for genuine new jobs and a pre-signal of a reduction in corporation tax, say to 25% from the present 28% over five years, to prevent firms shifting their domicile out of Britain during the recession and taking their tax with them.

There are good ideas there, some of which won't cost much, if anything, in the medium term. Over to you, Darling.

From The Sunday Times, November 9 2008