The Nationwide reported that house prices have slipped by 0.5% this month, and are now just 2.7% up on a year earlier. This followed Land Registry figures showing a 0.9% rise in house prices in January. Details of the Nationwide release are here. Meanwhile, the Bank of England said that mortgage approvals edged up to 74,000 last month, from 72,000 in December. They’re still very subdued, but not collapsing. Details here.

The dollar's latest dive, apart from taking sterling back towards the $2 level, has pushed the euro above $1.50 for the first time since the single currency came into being in January 1999. Good for US exporters, not necessarily for US inflation or confidence in the American economy.

Timing is everything in this game. Within hours of last Sunday’s piece, saying one key element of Alistair Darling’s recovery plan should be avoiding the nationalisation of Northern Rock, he was announcing that very thing at a hastily convened Treasury press conference.

A week on, I have not changed my mind that it was the wrong thing to do. It appears that once the Office for National Statistics had decided Northern Rock’s debt had to go onto the government’s books come what may – guaranteeing that one of Gordon Brown’s fiscal rules would be broken – the game was probably up for the private-sector solutions.

If the private sector could not take on the risk, it was not going to be allowed to get its hands on the return. The Treasury, in pursuing the private-sector option until last weekend, may have been going through the motions.

The question of whether the proposals from Virgin or the Northern Rock board could have generated greater long-term value for taxpayers went out of the window, sent packing by the political fear that in a few years’ time Sir Richard Branson would be partying off the profits on Necker Island.

It may be that Ron Sandler, Northern Rock’s new nondom executive chairman, and his team will do a great job. He has called in McKinsey, the consultants, which some will applaud, others not. But many talented business people have foundered in the public sector – Whitehall doesn’t usually know best.

The Northern Rock crisis is about more than Northern Rock. For days commentators have been scouring the historical record for parallels. Most of us do not stretch back as far as the last big bank run, Overend & Gurney in the 1860s. The secondary banking crisis of the early 1970s is more familiar territory.

Then, as now, the global economy had been through a period of exceptionally strong growth. Commodity prices were soaring. Nationalisation was already in vogue. When, in 1973, secondary banks got into trouble after overlending on commercial property, the Bank of England organised a lifeboat to bail them out and took some under its wing. The crisis marked the start of the damaging economic instability and the “stagflation” of the 1970s.

Another candidate, at least in terms of reputational damage to the government and Britain, was Black Wednesday, September 16, 1992. Norman Lamont, chancellor at the time, insists its role has been exaggerated in the telling.

He would say that, but he has a point. Labour went into a big poll lead immediately after but a year later it had halved. Really big Labour leads did not come until Tony Blair became leader and the Tories tore themselves apart over Europe and sleaze. And Black Wednesday had a happy economic ending: Britain did infinitely better outside the ERM (exchange-rate mechanism) straitjacket.

So what will we think about Northern Rock in a couple of years? Will it be regarded as a housekeeping exercise well on its way to resolution as the debt is paid off? Will it be seen, like the secondary-banking crisis, as marking the beginning of a period of the “great instability”, replacing the great stability of recent years? Could it be that Labour will soon be tearing itself apart, as worried MPs start to speculate openly, not just about Darling but about Brown?

As far as reputation is concerned, the damage was done before last weekend. Brown, having enjoyed high approval ratings throughout his chancellorship, slipped at the final hurdle. Conservative claims that his final budget in March last year was a con trick (the income-tax cuts that weren’t) hit home.

By summer, the new prime minister’s honeymoon gave Labour a small lead in the monthly question on economic competence - who do you trust to raise your family’s standard of living? - run by YouGov for this newspaper. That fell away in the autumn, due to Northern Rock and the wider credit crisis. But a Populus poll for The Times , since the nationalisation announcement, shows Labour back in the lead.

The main conclusion from the polls suggests, however, that voters have a “plague on all your houses” attitude on competence, favouring neither the Tories nor Labour. The government is suffering but the opposition is not yet presenting a convincing alternative. This is why Brown’s advisers think that, if Northern Rock is seen ultimately to have been well handled, it will do the government a lot of good.

What matters most is the kind of economy we will have over the next couple of years. Kate Barker, the longest-serving external member of the Bank of England’s monetary policy committee (MPC), gave a gloomy assessment last week.

Perhaps it was because she was back in her native Stoke but she struck a downbeat tone, warning that “a prolongation of the present difficulties in accessing wholesale funds could restrict the quantity of mortgage lending during 2008 . . . feeding back into a decline in the housing market, somewhat lower consumer spending, and also into lenders’ balance sheets, reducing lending capacity further”.

These are the negative feedback effects the Bank is worried about and which would also have implications for Northern Rock. She went on to warn that a severe credit tightening could hit growth hard, in a way that “could prove difficult to turn round quickly”.

The MPC is singing from the same hymn sheet. Andrew Sentance, in a speech on Thursday in Exeter, addressed head-on the question of whether there would be a recession. His conclusion was there would not be, at least in terms of an outright, year-to-year drop in GDP. But he warned the slowdown in growth might be “more significant and sustained” than any in the inflation-targeting era, which stretches back more than 15 years.

Sobering stuff. We are, however, mainly still waiting for the slowdown shoe to drop. Somebody needs to tell Britain’s shoppers that tougher times lie ahead. Retail sales volume jumped 0.8% last month and was 5.6% up on a year earlier. Sales of household goods rose nearly 10% in the latest three months, their best for six years.

In industry, the CBI said manufacturers were enjoying their longest run of sustained demand for 12 years, measured by the orders balances in its monthly surveys. The good news on tax revenues, something I touched on last week, did not speak of an economy weakening sharply. Revenues are a backward-looking indicator but their 12% annual rise in January was impressive.

There are plenty of storm clouds gathering, which will determine how much trouble the economy is in. So far, however, the worst is holding off. And the government will still hope to avoid being hammered by the Rock.

PS: Immigration is fascinating, and a new report from the Organisation for Economic Cooperation and Development, A Profile of Immigrant Populations in the 21st Century, has some juicy nuggets. We forget that Britons are often other countries’ immigrants. Three million of us live in other OECD nations.

Britain is a net exporter of the highly skilled to advanced economies; 14.9% of ours work in other OECD countries while only 6.5% of the highly skilled here are from there. We import skilled people from less advanced countries – they are nearly 10% of the highly skilled in Britain. To compensate for our brain drain, we drain developing nations. Not good.

From The Sunday Times, February 24 2008

Nobody appears to have told Britain's consumers that they are supposed to be battening down the hatches. Amid tumbling consumer confidence and deepening debt worries, retail sales volume rose by 0.8% last month and was a hefty 5.6% up on a year earlier. Though supported by price cuts (sales value was up by 4.8% year-on-year) there appears to be some underlying strength. The volume of household goods sales in the latest three months rose by 9.8%, the fastest since February 2002. More details here.

The Bank of England's monetary policy committee voted unanimously to cut rates earlier this month, the only "dissenter" being David Blanchflower, who voted to cut by half a point rather than a quarter. The Bank is clearly concerned about the downside risks to growth and the MPC clearly regarded the decision to cut as something of a no brainer. That must argue for further cuts, despite the cautious tone of the February inflation report. The minutes are here.

The Treasury, having examined the two remaining private sector bids for Northern Rock, has decided neither served the interests of the taxpayer, so Alistair Darling has announced nationalisation. As set out below, many of us will need a lot of persuading that the return of the failed model of nationalisation is the best way out of this mess. Since it is unthinkable that a nationalised Northern Rock could compete with the private sector on level terms for an extended period, the Treasury talks about temporary public ownership. In his statement, Alistair Darling also talks about the bank being run on an arm's length basis from the government and of it being returned to the private sector when financial conditions permit. His full statement is here.

These are dark days in the Treasury. Last October's hasty and openly political pre-budget report is unravelling faster than one of your granny's scarves, Northern Rock sits like a great fat cuckoo in the nest, and officials are praying that figures this week will bring some relief from the string of awful releases on the state of the public finances.

For years, the Treasury was famous for attracting fine minds in bad suits, happy to work in its austere, maze-like, red-lino floored building. Now it has modern, airy, high-tech headquarters that would not be out of place in a dotcom firm. The dress code is casual. But the Treasury's reputation has rarely been lower. Even the political columnist of the Financial Times, usually a friend of the department, is calling for its break-up.

Are the Treasury's problems simply down to the fact that Alistair Darling, so far at least, turned out to be a surprisingly accident-prone, unintentionally headline-grabbing chancellor?

I shall return to him in a moment. The Treasury's difficulties, however, were in all important respects created during the 10 years that Gordon Brown was chancellor.

From the moment Brown and his aides walked into the Treasury in May 1997 and started handing out orders, it was clear that the relationship between ministers and officials would be different from ever before. Margaret Thatcher liked to distinguish between people who were "one of us" and those who were not, but her chancellors worked well with the Treasury they inherited.

Under Brown the wave of departures among officials started from the very top and continued. As the old Treasury left, so the politicisation of the new Treasury gathered pace. When Ed Balls, Brown's Labour party aide, now a minister, was appointed chief economic adviser, normally a post for a civil servant, that process was set in stone.

There are two reasons why all this is relevant now. The first is that, so much was the post-1997 Treasury geared around Brown that when he eventually moved on (taking a string of officials with him) it was left like a ship without a rudder; Hamlet without the prince.

The second was that officials lost the "Yes, Minister" ability to say "No". Opposition to policies would be construed as opposing the Brown-Balls project and thus disloyalty. This reached its nadir with last October's pre-budget report, essentially a party-political broadcast dressed up as a Treasury statement, and with damaging consequences. Somebody should have said no.

So is there anything Darling can do to claw back his own, and the Treasury's, reputation? It's a tough job but somebody has to do it, so let me try.

His first task is to try to undo some of the damage caused by his efforts so far. Let us be clear, there is a case for making "non-doms" pay some tax, even £30,000 a year, just as there was a case for simplifying an overcomplicated capital-gains-tax (CGT) regime. There was no case, however, for rushing through changes to either, particularly taxation of non-doms, over which Brown fretted for years. If it was easy, then even Brown, who takes his time to come to decisions, would have acted.

My sense is that on both CGT and non-doms, Darling has made as many concessions as he intends, and both will be pushed through in the March 12 budget. But there is a powerful case for further consultation, if necessary putting the changes on ice for 12 months, as groups like the Institute of Directors have said.

Second, the chancellor should review, and if necessary rewrite, the fiscal rules. This is not a time for tax hikes — it rarely is — and the inclusion of Northern Rock debt on the government's books has already temporarily bust one of the fiscal rules — that debt should stay below 40% of gross domestic product.

But the golden rule, which means in effect that the government should only borrow to invest, has proved itself to be unsuitable, allowing too much borrowing during the good times and leaving the public finances vulnerable during a downturn.

It has meant that while most other countries have been reducing their budget deficits, Britain's has been rising. The rule means that the norm for public borrowing is more than 2% of GDP, currently in excess of £30 billion and rising to £40 billion. That is too high.

As I say, this is not the time for immediate radical fiscal action, but Darling would do himself and the Treasury a lot of good if he announced that, over time, the intention is to move to a tougher fiscal rule, with a borrowing norm of no more than 1% of GDP and even smaller increases in government spending than the 2% annual real rises that are being planned at present. Third, the Treasury has to get Northern Rock off its hands. We will know more this week but it would be a terrible mistake if nationalisation was left as the only option because of government insistence on driving a hard bargain. That drove Olivant away and it could yet see off Virgin's bid. Whatever Vince Cable says, it is far better that somebody makes money out of rescuing it than that the dead hand of nationalisation makes an unwelcome comeback.

Finally, if Darling wants to make himself really popular with business he should do something about a problem that is as big a burden as rising taxes and, for a government strapped for cash as this one, cheaper to tackle.

The British Chambers of Commerce will say this week that the cumulative burden of red tape on business under this government has reached £66 billion, and is rising by £10 billion a year. Brown promised to tackle this and the Department of Trade and Industry was deliberately renamed the Department for Business, Enterprise and Regulatory Reform.

But the BCC's exercise shows that the tide of red tape continues and that examples of reductions are as rare as hen's teeth. George Osborne, the shadow chancellor, proposes an Office for Tax Simplification. If Darling were to apply his lawyerly brain to doing something meaningful in this area, he could do a lot of good. He could, indeed, yet turn out to be a good chancellor.

PS: For a man who expects to write a second letter in the coming months explaining why inflation has risen above 3%, at a time when the economy is slowing sharply, Mervyn King was surprisingly upbeat last week in presenting the Bank of England's quarterly inflation report.

One skip doesn't make a summer but it's a start.

From The Sunday Times, February 17 2008

A curious Lex column in the Financial Times this morning, which says the following, under the headling Pounded:

"Sometimes currencies do what they’re supposed to. Last year analysts were at odds as to why the British pound was so strong (the lazier explanations included the lure of London and that the country speaks English). But by the year end they were virtually unanimous that sterling would fall – and so it has. Compared with the highest exchange rates recorded last year, the pound is down 15 per cent against the yen and the euro. Versus the dollar, which itself is in a tail-spin, sterling has lost 7 per cent of its value."

In fact, forecasters who by the year end were unanimous in predicting that sterling would fall were behind the game - it already had, though from a position where a year ago it was at its highest level since the early 1980s. The story of the first few weeks of this year has been one of sterling stability. The sterling index is roughly where it was at the start of the year and the Bank's broader trade-weighted index is up. Sterling may well fall this year. It hasn't yet.

The Bank of England's inflation report set out the dilemmma between a significant rise in inflation in the short-term and a sharp slowdown in growth. It left open the door to lower interest rates - on unchanged rates inflation will undershoot the 2% target in two years - but not the kind of cuts the markets are expecting. Compared with market expectations of a reduction to 4.5%, the Bank is signalling a cut to 5% or 4.75% (my forecast).

This was an interesting report. Mervyn King, while warning that the risks to the growth forecast - which will see it declining to a low of around 1.5% - went out of his way not to be too gloomy. He thinks it is odds-on that he will have to write a letter explaining why inflation has moved above 3% (or below 1%) over the next two years but appears unfazed by that. He also said that house prices should be in for a long period of stability.

The broad message was that the markets have got somewhat ahead of themselves on rates but that further cuts are likely, in spite of the short-term inflation problem. The report is here.

Also today, labour market statistics were published showing that things remain healthy, with a 16th consecutive fall in claimant unemployment and a 175,000 quarterly rise in employment. The job market is holding up well at a time when earnings growth remains steady. Here's the release.

Consumer price inflation rose only slightly, to 2.2%, from 2.1% in December. After yesterday's producer price numbers, something a lot worse might have been expected, so the figures came as something of a relief. RPI inflation also rose, from 4% to 4.1%. RPIX inflation, the old target measure, increased from 3.1% to 3.4%, close to the point where it would have triggered a letter from the governor in the old days. More details here.

Users will notice that comments on the site are closed. I do this with regret but a plague of spammers and moronic nuisance callers makes the task of moderating too time-consuming and has spoiled it for the rest. The discussion forum remains open. Those who want to join should register by clicking on it, then e-mail me with their user name.

Official figures showed a nasty jump in both input and output prices, with output price inflation now up to 5.7%, its highest since 1991, and input price inflation a hefty 19.1%. Core output price inflation was 3.1%. The figures underline the Bank of England's dilemma. Details here. Also today, the trade deficit on goods and services narrowed to £4.7 billion in December but this was no cause for celebration - the November figure was revised up from £4.4 billion to £4.8 billion. Overall, there was a deficit of £51 billion in 2007, up from £46.4 billion in 2006. Details here.

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We know, thanks to the Bank of England’s decision on Thursday, where interest rates are in the short term. But where are they heading in the next few months? And will we look back on this period as a time of unusually low or high rates, or something close to the norm?

It is a big question. The days when the nine members of the monetary policy committee could happily slash interest rates in response to international events such as the 9/11 attacks on America or the Iraq war appear to be over.

Last week’s decision to cut Bank rate from 5.5% to 5.25%, and the statement that accompanied it, epitomised the “difficult balancing act” Mervyn King has warned about. On one side there is the risk that a short-term rise in inflation will become ingrained in inflationary expectations and pay. On the other was the risk that a “sharp slowing in activity pulls inflation below the target in the medium term”.

The governor still looks forward to the “calmer waters” of low inflation and a better-balanced economy. No doubt he is at this moment thinking of a colourful analogy to present alongside this week’s inflation report.

Some talk about the Bank’s problems being tantamount to stagflation; stagnation combined with high inflation. As somebody who does remember the 1970s, and paraphrasing a famous American political riposte: I knew stagflation; this is no stagflation.

So where is Bank rate likely to settle? When it rose to 5.75% last summer, there was plenty of talk of it climbing to 6%, 7% or even 8%. Some of the same people who were predicting those rises are now forecasting falls to 4%.

There is, however, something like an invisible elastic that pulls the rate back towards its norm whenever it threatens to move too far away from it.

When the Bank was granted independence, nearly 11 years ago, its initial task was to establish its antiinflation credibility. Bank rate, 6% on the day of the independence announcement, was raised to 7.5% a year later.

If we exclude the first 18 months, when the Bank was gaining its spurs, the rate has been no higher than 6% and no lower than 3.5% since. I would argue 3.5% was a bit of an outlier, which is unlikely to be repeated any time soon, so the “normal” range we should be thinking of is probably 4% to 6%. Interestingly enough, the average Bank rate since early 1999 has been 4.8%.

This is worth noting because it is in my view close to the “neutral” interest rate for Britain, which I think is in a 4.5% to 5.5% range. By neutral I mean a rate that is neither restraining nor stimulating the economy. You would expect the rate at neutral when the economy is growing in line with trend, 2.5% to 2.75% a year, and inflation is hitting its 2% target.

Members of the Bank’s monetary policy committee occasionally talk about the neutral rate but it is, if not a banned expression within the hallowed halls of Threadneedle Street, officially frowned upon. I would not expect to find it, for example, in this week’s inflation report.

Sir John Gieve, one of the two deputy governors, came close last month when he talked about the growth slowdown possibly justifying “a progressive shift in policy – from restrictive to a more neutral stance”.

Part of the Bank’s reluctance to commit itself is that a neutral rate implies that monetary policy is more rigid and mechanistic than it is. The neutral rate may not be the same in all circumstances.

Even if you regard it as a useful concept, which I do, there will be periods when the rate has to be above neutral, as it has been in recent months. It is also possible, depending on the impact of the credit crisis and the extent of this year’s slowdown, that we will have to go below neutral. My prediction is of a 4.75% Bank rate by the end of the year. Others are looking for more aggressive cuts.

Recent data have been less than reassuring for those, including King, looking for a rebalancing of the economy but not so bad in terms of growth. The purchasing managers’ survey for the service sector last week was stronger than expected, while its counterpart for manufacturing was weak. The economy is slowing rather than diving, allowing the Bank to pursue a gradualist approach to cutting rates, in contrast to the Federal Reserve. You will know the wheels have come off if the Bank goes into slashing mode.

What about the longer term? Though bond markets have to form a view of interest-rate levels in the long run, it is a brave economic forecaster who does so. Could it be that we have seen the best of low inflation and that rising food and energy prices, coupled with the end of the maximum impact of the China effect on goods prices, mean inflation will be much more troublesome in the next 15 years than in the past decade and a half?

The National Institute of Economic and Social Research, in its latest review, had a stab at projecting rates into the murky future. Assuming growth averages 2.5%-2.6%, inflation is close to target on the CPI and between 2% and 2.5% on a broader measure, the gross domestic product deflator, it comes up with an interest-rate average of 5% for 2009-11 and 5.1% for 2012-16.

That is in the middle of my neutral range and just above the recent average but by no means daunting. After all, it is not so long ago that the norm for UK rates was in double figures. So if anybody asks you for a number on where interest rates will be in 10 years’ time, just say 5%.

PS: Television viewers may be confused. For years, a staple of the schedules has been programmes about how to move up the property ladder. Only antiques programmes have been more popular.

Finally, my mention of Britain’s transport shortcomings and their effect on economic growth created something like gridlock in my e-mail inbox, confirming that this is a national issue. I’ll address it soon. Given that Brown commissioned Sir Rod Eddington to investigate it, it will be interesting to see whether anything has been done on the back of his recommendations made more than a year ago.

From The Sunday Times, February 10 2008

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Finance ministers and central bankers from the G7, at their meeting in Tokyo, warned of slower global growth but said America should escape recession. This is part of what the G7 - America, Britain, Japan, Germany, France, Italy and Canada - said in their statement.

"In all our economies, to varying degrees, growth is expected to slow somewhat in the short term, reflecting wider global economic and financial developments ... Going forward, we will continue to watch developments closely and continue to take appropriate actions, individually and collectively, in order to secure stability and growth in our economies.”

There were no new initiatives on currencies. The tone of the meeting, which warned of significant downside risks to growth, a view shared by the European Central Bank, suggested that further rate cuts are on the way.

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The Council of Mortgage Lenders has reported that there were fewer mortgage repossessions - the proper word is possessions - last year than feared. It had expected 30,000 but has today reported just over 27,000, with virtually no change between the first and second halves of the year. This may also mean that the 45,000 possessions figure feared for this year is also too pessimistic. Details here.

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The Bank of England duly cut Bank rate from 5.5% to 5.25%, as expected. It emphasised the downside risks to UK and global growth but the upside risks to inflation, particularly in the short term.

Here's part of what the Bank said:

"The prospects for output growth abroad have deteriorated and the disruption to global financial markets has continued. In the United Kingdom, credit conditions for households and businesses are tightening. Consumer spending growth appears to have eased. Although the substantial fall in the sterling exchange rate is likely to promote re-balancing of total demand, output growth has moderated to around its historical average rate and business surveys suggest that further slowing is in prospect. These developments pose downside risks to the outlook for inflation.

CPI inflation, at 2.1% in December, was close to the 2% target, but higher energy and food prices are expected to raise inflation, possibly quite sharply, in the coming months. And the lower level of sterling will boost import costs. The impact on inflation should begin to fade later in the year, but measures of inflation expectations are currently elevated. These developments pose upside risks to the outlook for inflation further ahead.

Given this outlook for inflation, some slowing of demand growth, by reducing the pressure on capacity, is likely to be necessary to return inflation to target in the medium term. The Committee needs to balance the risk that a sharp slowing in activity pulls inflation below the target in the medium term against the risk that elevated inflation expectations keep inflation above target."

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The Halifax reported that house prices were unchanged last month which, following Nationwide's report of a 0.1% decline, shows rare unanimity among the lenders' measures. Halifax prices were up by 4.5% on a year earlier. Recent data supports the view that there was a Hips (home information packs) distortion to house price indices in the final months of last year, and that November was the point of maximum weakness. But the effect of very weak approvals' data may yet to have come through fully.

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Imagine, for a moment, you are a member of the Bank of England’s monetary policy committee (MPC). If you are Mervyn King, the governor, you have been reappointed for a second five-year term, with plenty of time to make good the recent damage to the Bank’s reputation. If you are Andrew “uber-hawk” Sentance, another MPC member, you have also been reappointed. So what do you do?

You start, as the Bank always does, by looking at the global economy. There has been a lot of nonsense talked about world recession, given that we are coming out of a period in which the global economy has enjoyed four years of near-5% annual growth, the best for three-and-a-half decades.

True, America slowed to a crawl in the final quarter of last year, its economy expanding at an annual rate of only 0.6%. Hence the nearest thing you will see in central banking to a red alert: the Federal Reserve cutting US interest rates twice, by a combined 1.25 percentage points, in eight days.

But China, India and other emerging economies are growing rapidly and likely to continue to do so. The most significant thing in China last year was that consumer spending, rather than exports and investment, made the biggest contribution to growth, with retail sales up 17%. The American slowdown will nudge China’s growth down but still leave it at about 10%.

America’s gross domestic product, $13,843 billion, was four times the size of China’s, $3,430 billion, last year. But even on this basis, China’s economic growth of 11.4% made a bigger contribution to the world than America’s 2.2%.

When the numbers are adjusted for relative prices, so-called purchasing power parity, as they should be, China is 45% of the size of the American economy, and 10% of the world. So last year just under a quarter of global growth came from China. This, the year of the Beijing Olympics, will again see the biggest contribution of any country coming from China, notwithstanding the severe winter snows.

Add in India, Opec, Russia and Brazil, and well over half of global growth this year will come from outside the G7. If you are sitting on the MPC, then, you will be reasonably reassured that growth is not collapsing. The International Monetary Fund’s new forecast, of 4.1% global growth this year, is down on last year’s 4.9% but still strong. Between 1998 and 2003, for example, global growth averaged only 3.3% a year.

You would not, however, be too reassured. Just as it is possible to have the wrong kind of snow, it is possible to have the wrong kind of global growth. Britain’s economy is not as tied in to growth in China, India and other booming economies as it should be. The slowdown in America and Europe, with the IMF predicting 2008 growth of 1.5% and 1.6% respectively, will have a significant negative impact, only partly offset by what is happening elsewhere.

What about closer to home? Growth in the final quarter of 2007, 0.6% (actual, not annualised), was close to trend. It is slowing, not collapsing, but will soon be growing below trend.

Mortgage approvals in December, 73,000, were below the lowest point in the 2004-5 housing pause and point to further housing weakness, though the Nationwide reported a fall of only 0.1% in prices in January and thinks it has detected tentative signs that demand may be bottoming out.

Consumers, however, are cautious and so is business. The CBI said January retail trading was the weakest for 15 months. Consumer confidence did not improve as much as it normally does between December and January, and remains weak.

There is a lesson for Britain on the other side of the Atlantic and it is that economic weakness can spread and become cumulative in its impact. The MPC would never want to get into the position in which the Fed has found itself, having to deliver panic rate cuts merely to steady the ship. This reinforces the argument for pre-emptive action.

In circumstances like these, the Bank could normally look down the road to the Treasury for a bit of help. Gordon Brown used to bore on about monetary and fiscal policy operating hand in hand, in a complementary way. No longer.

I have been accused of being too kind to Brown’s chancellorship, though not by Downing Street. On the public finances, however, I have long been critical. Exactly a year ago, I wrote of “Brown’s imprudent tax-and-spend legacy”. Other countries had reduced their budget deficits in the good times but not Britain and, as I put it: “If the economy hits the rocks, the public finances do not look robust enough to take it.”

Those chickens are coming home to roost. The Institute for Fiscal Studies (IFS), in its annual green budget — the real one will be on March 12 — predicts government borrowing will top £40 billion both this year and the following two years. In the absence of at least £8 billion of tax rises, Alistair Darling, the chancellor, will break both the government’s fiscal rules, it said, including the sustainable-investment rule that requires government debt over the cycle to be below 40% of gross domestic product. That, by the way, is excluding Northern Rock.

Governments have raised taxes in difficult times, the classic being Sir Geoffrey Howe’s austerity budget of 1981. The IFS does not think this one will, though it would like to see a nod in the direction of a fiscal tightening. I would argue that Darling has no choice but to let the deficit run above-target and hope for something — the economy and tax receipts — to turn up.

The fact is that there are no shots in the fiscal locker, all of them having been squandered by Brown. The Bank is on its own.

So that means lower rates, and the overwhelmingly expected quarter-point rate cut this week. A bigger cut would look risky at a time when, according to the latest Citigroup-YouGov survey, the public’s inflation expectations for the next 12 months have jumped from 2.7% to 3.3%, buoyed by rising food and energy prices, well above the 2% official target.

Cutting rates is not the “no brainer” for the Bank that it is for the Fed. The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, votes only 5-4 for a cut this week, showing there is still a debate to be had. One cutter, Peter Warburton, thinks the Bank should slash by half a point, but the other four were content with a quarter. The non-cutters are concerned about strong money-supply growth, the balance-of-payments deficit, sterling’s fall late last year and the “lax” fiscal background.

There will be some on the actual MPC who agree with these worries, including possibly King and Sentance. Each rate cut in the coming months will be the monetary-policy equivalent of pulling teeth, painful and involving lots of shouting. The Bank has to cut. But it is not the Fed.

PS: Long-suffering readers will know I set great store by my skip index, based on the number of builders’ skips in my street — two indicating the economy is on trend, four a boom, and none that we are in trouble. Despite extensive searching this past couple of weeks, sometimes at night, the index is still firmly on zero. Weak housing and subdued consumer confidence is taking its toll and I don’t suppose the weather is helping.

It is probably a bit of both. I will devote a column soon to the damage transport inadequacies are doing to the economy. Not to make it too London-centric I shall try to widen it, so any observations are welcome. In the meantime, I will keep looking for those skips.

From The Sunday Times, February 3 2008

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At its latest meeting, the IEA’s Shadow Monetary Policy Committee (SMPC), a group of leading monetary economists that monitors developments in UK monetary policy, voted narrowly to cut the UK Bank Rate by ¼%, rather than hold it at its current level.

All members of the SMPC were concerned by the problems that had arisen with sub-prime lending, the consequent impact on the property market, and the softening of economic activity. However, a substantial minority felt that earlier policy mistakes, which had led to British interest rates being kept too low for too long, meant that a reduction in rates should not take place now.

Those wishing to hold rates were concerned about a number of trends in the UK economy including: strong broad money growth; the large balance of payments deficit; the depreciation of sterling; the lax fiscal background; and output appearing to be above trend. The holders consequently felt that the Monetary Policy Committee (MPC) had to stay focused on its core inflation objective.

This view was summed up by David B. Smith, Chairman of the Shadow Committee who said, ‘The December rate cut was an error because it risked de-stabilising sterling…Furthermore, inflation expectations had been rising, both in Britain and overseas…There is a real danger of global “stagflation”’.

However, the majority view, which was held by the five SMPC members who wished to cut rates, was that the deteriorating credit market conditions would lead to a serious slowdown in the economy. John Greenwood, Chief Economist at Invesco summed up the views of those wishing to cut rates commenting: ‘Events in the market for credit are sufficiently severe to create a significant downturn in economic activity.’

The SMPC meeting was held on 15 January. However, all committee members were given the chance to re-consider their vote following the 22nd January US rate cut. One switched from a ‘hold’ to ‘down ¼%’ as a result.

The minutes of the meeting are attached below. Minutes of all recent SMPC meetings are available from the SMPC section of the IEA website at www.iea.org.uk. The SMPC, which has shadowed the MPC since its creation, meets quarterly but also conducts a regular e-mail poll in intervening months.

It normally publishes this, together with a poll on the Committee’s view on interest rates, on the Sunday before the Thursday Bank Rate announcement.
The results of the latest Shadow Monetary Policy Committee (SMPC) quarterly gathering (carried out in conjunction with the Sunday Times) are set out below. The rate recommendations are with respect to the UK Bank Rate decision to be announced on Thursday 7th February.

Minutes of the Meeting of 15 January 2008

Attendance: Philip Booth (IEA observer), Tim Congdon, John Greenwood, Ruth Lea, Andrew Lilico, Kent Matthews (Secretary), David Brian Smith (Chair), Peter Warburton, Trevor Williams, Melanie Powell (Derby University observer), Eugen Mihaita (Derby University observer).

Apologies: Patrick Minford, Gordon Pepper, David Henry Smith (Sunday Times observer), Alistair Heath (The Business observer).

Chairman’s Comments

David B Smith welcomed Melanie Powell and Eugen Mihaita from the University of Derby as observers to the meeting and reminded members to complete the mini-biographies for the media contacts list.

David B Smith invited Peter Warburton to give his assessment of the world and domestic economy.

The Economic Situation

The International Economy – increased risk environment and softening of economic activity.

Peter Warburton referred the committee to the briefing charts and began by stating that world economic activity in the third quarter of last year, when much of the published data expires, was not a good guide to what is to follow. The third quarter figures confirmed that growth of world economic activity was solid. However, a composite leading indicator is signalling a sharp downturn in the seven largest developed economies. Another indicator of world trade was the Baltic Freight index which was showing a severe downturn, even after allowing for seasonal effects. Similarly, exports from the three major far Eastern exporters - China, Korea and Taiwan - were also showing a growth slowdown.

Peter Warburton added that US consumer spending in the third quarter was still strong but unemployment had edged up with layoffs in the financial sector showing the largest rise. Non-financial corporate profits growth has turned negative.

Even so, a weighted measure of broad money supply for fifty of the largest nations had accelerated in October. One interpretation was the repatriation of credit market debt back onto bank’s balance sheets. But global core and headline inflation has risen in recent months. Indicators of US inflationary pressure picked up in November but worsening inflation indicators have not prevented ten-year yields in US Treasury bonds from declining. The riskier environment is reflected in corporate bond spreads which have widened and credit default spreads which have increased markedly. Fed funds futures indicate that further cuts in interest rates. The market is currently expecting a further 60 basis points (0.6 percentage points) reduction by the end of January.

The Domestic Economy – A softening outlook

Peter Warburton began his discussion of the economic outlook for Britain by stating that: indicators of consumer confidence had shown a sharp decline, despite the fact that the spread of the London Inter-Bank Offer Rate (LIBOR) over the official Bank Rate had settled down to a more familiar level; mortgage lending was running at a slower pace than in the previous year and growth in retail sales had softened in recent months; and overall house price inflation had softened with commercial property values showing a sharp decline.

M4 growth slowed sharply in October and November, although the latter figure was subsequently revised upwards. The year-on-year growth of M4 broad money was reported as 11.7% for November and the rate of growth of M4 lending remained steady at recent levels. A significant portion of bank assets are unaffected by interest rate cuts because of securitization. Cuts in rates are not being fully passed on to customers as financial intermediaries seek to restore margins. Sterling has depreciated suddenly in response to market expectations of future interest rate cuts.

The recent national accounts figures confirmed that the British economy suffered from serious imbalances. The third-quarter current account deficit, at 5.7% of Gross Domestic Product (GDP), was one of the worst on record. Credit tightening will weaken activity in the private business and financial service sectors, which together generate 60% of GDP growth. Consumer Price Index (CPI) inflation is at 2.1%, close to the 2% reference rate, and core CPI inflation at 1.4%. Headline Retail Price Index (RPI) inflation is 4% and RPI excluding mortgage interest (RPIX) runs at 3.1%, showing no change over the last three months. The decomposition of RPI shows that it has been externally-determined and administered prices that have been growing sharply in recent times while the rate of private sector generated price inflation has been falling.

David B Smith thanked Peter Warburton for his presentation and opened the meeting up for discussion.

Discussion and Policy Response

Discussion
Growth slowdown in 2008

Trevor Williams started the discussion by asking for clarification on the US broad money supply figures. In replying, Peter Warburton said that financial innovation has created synthetic demands for short term assets that have created shifts in both the demand and supply of money. The potential for this type of money to migrate to consumer spending is low. Tim Congdon agreed that, in the case of US broad money, there had been some artificial inflation of bank balance sheets but China and India has strong money growth as indicated in the world broad money figures. He said that he expected world economic growth to slow to 3% against a traditional 4%.

David B Smith said that to him the current economic situation felt more like the period in the late 1960s and early 1970s, after Richard Nixon had broken the US$’s link to gold and world inflation was taking off, than it did to a re-run of the Great Depression. People who wanted to cut rates aggressively in the UK were doing so on the basis of the, as yet untestable, hypothesis that the global credit crunch was going to drive down UK growth very sharply indeed. He did not deny that this could happen. However, there was no evidence in the data that it was happening so far, or that money and credit growth were turning sharply negative. David B Smith added that, if one was discussing the 1930s slump, it was worth bearing in mind that not one bank in the then British Empire had gone bust during this period, whereas several thousand had gone under in the US, and that the severity of the inter-war recession in Britain was only approximately half that recorded in the US and Germany. He did not deny that the US may be heading into recession, but he thought that the UK was already so far into the overheating zone that it should not simply follow US monetary initiatives. He reminded the committee that the size of the balance of payments deficit in relation to GDP was a prima facie indicator of the excess of domestic demand over home supply in a small open economy, such as Britain’s.

Andrew Lilico asked to what extent are the downside risks interdependent and to what extent are the inflation risks interdependent? Peter Warburton said that, if the tightness of credit continues, he believed that things will go badly wrong for the economy. The UK is more highly geared than the USA so if credit gets re-priced the impact is stronger in the UK. He also added that while the spread between LIBOR and Bank Rate has fallen back to normal levels this could widen again in the future. He said that the increased risk would be priced into spreads as hidden losses emerge. Ruth Lea said that central banks might now respond faster - if that were to happen - and make liquidity available, while Tim Congdon said that banks use write-offs strategically. He added that the extent of write-offs may be overdone and that write-backs may occur. Trevor Williams suggested that spreads are like speculative bubbles which eventually burst.

John Greenwood stated that there are huge amounts of liquidity outside the banking system. When the Japanese bubble collapsed, non-bank finance imploded which resulted in strong effects on the real economy. The avoidance of Basle regulations had led to the fast development of non-bank credit. Peter Warburton agreed that the proliferation of credit channels has confused the operation of monetary policy. Philip Booth said that he was sanguine about the cycle. Low rates of interest, strong credit growth, and fast house price inflation that had not as yet fed into goods price inflation had to be slowed and that is what is happening.

David B Smith stated that this was one of the most interesting SMPC meetings that he could recall – in large part because of the genuine uncertainties involved and the fact that the standard macroeconomists toolkit had little to say on issues such as credit rationing – but that time was now running out, unfortunately.

Individual Votes

David B Smith then asked the members of the committee to vote on a rate recommendation.

Comment by Philip Booth
(Cass Business School and Institute of Economic Affairs)
Vote: Cut by ¼%
Bias: Neutral

Philip Booth said that previous unduly low UK rates of interest, strong credit growth, and fast house price inflation had arisen partly because the Bank of England had been asked to target a price index – the CPI - that excluded the cost of housing and gave greater than proportionate weight to goods whose relative price was falling, such as tradables. This has had inevitable consequences that must be allowed to unwind.

Loosening monetary policy to deal with the consequences of the losses from sub-prime etc. was not the right approach though, if there were a sharp change in consumption and savings behaviour, this might well justify a fall in interest rates. Given the downward international pressure on interest rates, and Britain's status as a small open economy, he thought that a 0.25% cut would seem to be in order now, but no more.

Comment by Tim Congdon
(London School of Economics)
Vote: Hold
Bias: Neutral

Tim Congdon said that during the credit crisis he had asked for a ½% cut, but the situation has changed with the fall in the value of sterling. The UK economy has a positive output gap of perhaps ½% to 1%, which argues that a relatively mild slowdown will be sufficient to keep inflation on target. At current rates there will be a sharp slowdown in broad money growth. Asset price weakness has been severe in some areas (such as commercial property, and property, financial, retail and cyclical sectors of the stock market). But – given the apparently ample money balances – this seemed to be best explained as a shock to confidence (i.e., a rise in the desired ratio of money to assets). He voted to hold, with a neutral bias.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ¼%
Bias: Neutral

John Greenwood said that events in the market for credit were sufficiently severe to create a significant downturn in economic activity. He voted to cut by ¼% in February with a neutral bias thereafter.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

Andrew Lilico said that the December cut in rates was due to credit market conditions and was clearly an error. The Bank of England had not allowed interest rates to rise high enough and therefore the possible extent of any rate reduction is limited. The inflation target is more important than slowing growth. The dominant risk to growth comes from falling house prices leading to weakened consumption. He voted to hold in February and had a neutral bias subsequently.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: To ease

Ruth Lea said that the Bank faced a clear dilemma. On the one hand, there were signs of slowdown and the housing market seemed to be turning down. But it was worth remembering that an overheating economy (and housing market) was the reason for the Bank to raise rates from mid 2006 to mid 2007 and indeed, before August’s ‘credit-crunch’ crisis, it was widely expected that official interest rates would be raised further. The surprise was that the housing market was as resilient for as long as it was.

On the other hand, inflationary pressures were intensifying reflecting high commodity prices exacerbated by a weakening currency – which may, in turn, help Britain’s appalling trade data. Too little attention had been paid to the falling pound. Under these circumstances, the Bank should behave cautiously and, on balance, hold rates in February. Bank Rate at 5½% was, however, on the high side and her bias was towards cuts.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: Neutral

Kent Matthews said that he was persuaded by the argument that credit market conditions would translate into a significant slowdown in the economy. However, it is also clear there are dangers in cutting interest rates too rapidly. Therefore the Bank’s policy of cutting interest rates in stages is the correct policy. Bank Rate cuts are unlikely to be translated into cuts in lending rates on one-for-one basis and therefore the cuts in rates are a means of shoring up declining consumer confidence and housing market pessimism. He voted to cut Bank Rate by ¼% in February with a bias to hold thereafter.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Tightening

David B Smith said that the December rate cut was an error, in his view, because it had risked de-stabilising sterling, and wondered whether the Monetary Policy Committee (MPC) would have sanctioned a rate cut had they known the size of the current account deficit in the third quarter and the adverse revisions to earlier data. Broad money growth in the UK and the OECD had been rapid, and in the case of the OECD area as a whole had been accelerating. This was not at all like the collapse of around one quarter in the absolute levels of bank credit and money seen in the US in the early 1930s. Furthermore, inflation expectations had been rising, both in Britain and overseas. This meant that, not only was the supply of real broad money balances growing rapidly in the world as a whole, but the demand for money might well be falling, because of the reduced real return from holding interest bearing deposits caused by lower money-market rates and higher inflation.

There was also a serious issue of policy inconsistency in Britain, with fiscal policy already far too lax and likely to be relaxed further in the next few years because of the postponed general election. The risk was that people believe that a 1930s type slump was imminent when the real danger was a global ‘stagflation’, similar to the one observed after Nixon went off gold. He voted to hold Bank Rate in February with a bias to raise rates in the future. He added that a necessary pre-condition for easing monetary policy in Britain, without taking undue inflation risks, was the implementation of a ‘Type 1’ fiscal retrenchment package, in which government spending was reined back, there was no increase in the tax burden, public capital formation was not cut, and labour market regulations were reduced. From a political perspective, he could see no prospect of that. Rather, he feared that a surreptitious, but highly damaging, ‘Type 2’ package of tax-raising measures would be attempted by the present government. He was surprised that more people were not concerned by the fiscal constraints on the MPC’s freedom of action.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Cut by ½%
Bias: To ease

Peter Warburton said that the credit crisis has tightened monetary conditions, as borne out by the Bank of England’s relatively new ‘Credit Conditions’ survey. An adjustment of 50 basis points is needed to allow for a widening of banks’ margins. Otherwise retail and commercial borrowers will find little relief. He expected a sharp slowing of economic growth. He said that action is needed now to forestall the downturn and voted to cut by ½% with a bias to further easing. He thought that Bank Rate had scope to fall to 4½% during the course of this year.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Cut by ¼%
Bias: Neutral

Trevor Williams said that rapid broad money growth remained a worry. The world economy is reacting to a bubble correction in the US economy, in housing and credit market. From the British perspective the higher inflation path occurs because of the openness of the economy. The output gap is not the sole drive of inflation and other factors, such as the exchange rate, also matter. This argues for interest rates to be held, as a weaker currency may drive up inflation pressure. But immigration in recent years has made the capacity of the economy a lot more flexible. Thus the output gap measure may be positive, but increased immigration had increased the capital stock though this was not yet being fully factored into measurements of the output gap. This link explains the current low rate of wage inflation, even as unemployment continues to fall modestly. He voted for a cut with a bias to hold if the economy did not slow down but he believed that the economy will slow down.

Votes in Absentia

The SMPC sometimes allows a small number of votes to be cast in absentia and adds their written submissions to the record of the meeting, to ensure that exactly nine votes are cast. On this occasion no such vote was required since nine SMPC members were present at the physical meeting.

Policy response

1. On a narrow vote of five to four the committee voted to cut Bank Rate by ¼% in February.

2. In particular, four members voted to cut the base rate by ¼% and one voted for a cut of ½%.

3. Of the five who voted for a cut in February, four had a neutral bias from March onwards and one had a bias to further cuts.

4. Four members voted to hold Bank Rate at its current position, with two having a neutral bias, one having a bias to cut, and one having a bias to raise interest rates.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group and Global Vision) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that a full set of nine votes is always cast.

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