Economic View: The Bank stood by while the house party got out of hand. But why be puritanical when the excess is over?

Just as interest rates weren't raised quickly enough before, so they should be cut now. The fragile markets need a signal
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The Independent Online

I have changed my mind about interest rates. I think the Bank of England ought to start cutting them this week. Just as it failed to raise rates swiftly enough to cap the housing boom, now it is in danger of making the same mistake in reverse: not softening the house price decline by cutting rates ahead of expectations.

I don't think a reduction will ease the gumming up of the money markets, which is increasing the cost and restricting the supply of mortgages. But there are times when the authorities need to give a signal to the markets, and that time is now.

The reason for thinking this is not that it is the job of the Bank's Monetary Policy Committee to try and micro-manage house prices. Its role must be to try to fulfil the duty put upon it to keep the consumer price index at close to 2 per cent.

I happen to think the CPI gives an unrealistic estimate of inflation and that the previous targeted index, the retail price index excluding mortgage interest payments, was a better one for policy purposes. Much more attention ought to be paid to this index (the RPIX) and to the RPI itself in the Bank's Inflation Bulletin, in MPC members' speeches and by the Governor of the Bank himself. People ought to know that the RPI is 3.9 per cent, and that it this the Government uses when determining all its payments, including pensions, benefits and the interest on index linked-gilts.

The principal use of the CPI, aside from allowing ministers to claim that inflation is low, is for the MPC. Intellectually, it is absurd to use a measure for policy that has no practical function.

Nevertheless, I still think, despite the worryingly high RPI, that the Bank should make a start in bringing rates down. Why?

The first point is that central banks have an overriding duty that preceded inflation targeting: maintaining financial stability. Inflation targeting is a useful tool towards achieving that goal. But it is only a tool and a relatively recent one that hasn't been tes- ted through several economic cycles. Checking, or at least trying to check, asset price bubbles should be part of this wider remit.

Controlling the price of money the rate at which a central bank will lend to the banking system is not the only weapon in the armoury but it is by far the most important, and in the case of the MPC, it is the only one at its command. The other principal weapon is regulation, which in the case of the UK is now largely but not entirely devolved to the Financial Services Authority, with none-too-happy results.

Central banks also have the weapon of "moral suasion", difficult to wield but useful at times. If, for example, the Bank had let it be known last spring that it was concerned at the extent to which some mortgage lenders were relying on money market deposits to fund their lending book, then at least the markets would have been prepared for the Northern Rock debacle, even if the Rock management failed to pay heed. But that is all past.

Where we are now is that the money markets remain very fragile, maybe more so than a few weeks ago. You can measure this by looking at the gap between the official Bank base rate of 5.75 per cent and the various money market rates, of which the three-month one is the most important. (Banks place their spare cash on the money markets while other banks short of deposits borrow that money back.) You would expect the three-month rate to be higher than the Bank of England one but by less than a quarter of a percentage point. Last week, the three-month sterling inter-bank rate was just under 6.6 per cent, a gap of more than three-quarters of a point.

During the summer, before the global banking crisis broke and when property prices were still soaring, I called for the Bank to increase rates to 6 per cent. It seemed much safer that it should give a strong signal things were getting out of hand than to allow the excesses to continue. I still think that judgement was right. But now the world has changed. If you look at what banks are having to pay for money market deposits, we have the equivalent of a Bank rate of at least 6.25 per cent. That must be too high for present economic conditions, both for commercial borrowers and for home buyers.

Let's leave the commercial borrowers aside and focus on housing. The property market has turned and the flow of mortgages is drying up. There is the question of price: I think people whose fixed mortgages run out will be disappointed at the new rates they have to pay. But there is also a question of availability. It varies across lenders but, averaged out, the British home loan market needs some money market deposits to keep going. Retail savings through branches are not enough.

Because lenders are struggling to fund themselves, they will have to tighten the standards under which they lend. Some rigour is welcome, but we don't want a swing from too lax a mortgage market to too tight a one. That is what seems to be happening.

So would a cut in the Bank's rate help? Well, a bit. The greater problem is at the two- and three-month level, not the overnight rate, but cutting very short-term rates would signal that the Bank is not being overly puritan. It would not, however, solve the problem, which is a global scramble by banks for spare cash ahead of the year-end. I saw that the European Central Bank was pumping money into the one-month and two-month levels. The euro money markets and indeed the dollar markets are under similar pressure. The ECB rate is 4 per cent but the one-month euro interest rate on Friday was 4.8 per cent.

There are probably other things the Bank should do over the next month to ease the pressure, for there is a perception that it has been less effective in assisting the banking system than either the US Federal Reserve or the ECB. You don't want to let the banks off the hook; they have to pay for their foolishness or they will make even bigger mistakes next time. But equally we don't want our housing finance market to dry up. That is why it seems to me to be much safer to start trimming UK rates at the MPC meeting this week.