Hamish McRae: Summertime and the living isn't easy, so it's time for the Bank of England to get cutting

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The Independent Online

It was one of those deceptively simple questions that brings you to a halt. I was talking at a school last week and was asked: "Do you think the Monetary Policy Committee has made an error by not cutting interest rates already?"

It was one of those deceptively simple questions that brings you to a halt. I was talking at a school last week and was asked: "Do you think the Monetary Policy Committee has made an error by not cutting interest rates already?"

Let me give you the answer first, the nub of which was: "Not yet, but it may have to cut rates very swiftly this summer." For much more important than the answer was the complex reasoning implicit in the question. The headline issue, of course, is whether the economy is experiencing a sharper slowdown than the Bank of England expected - more of which in a moment. But behind that lie a string of fascinating subsidiary questions, which deserve some tentative answers. Here are half a dozen of the more significant ones.

Was there a credible case for starting to cut rates earlier this year, on the evidence available at the time? Did the Bank's previous expectation of a rise in the inflation trend misunderstand the impact of China and India on developed-country costs? Are the lags in the economy's response to a rise in rates now longer than the Bank thought? Are consumers as confident as they say they are? Should the Bank have made greater allowance for the deteriorating external outlook? And could a swift cut this summer reverse an over-rapid slowdown?

When to start cutting? It would really have been very difficult to make a case for rate reductions until now. The sustained increases, starting in the autumn of 2003, did not succeed in curbing the housing boom until Christmas, and the consumer boom carried on into February. So in so far as the need to curb the boom was the main driver for the increases - I don't think there was any other real justification because inflation at a consumer level was very muted - there was no case for lower rates. The higher ones had only just begun to work.

Are we underestimating China and India? I think there is mounting evidence that having two huge, low-cost and increasingly well-educated workforces competing with us is keeping inflation down. You can see the direct impact on the prices of goods in the shops, which have been stable or falling for four years. But the indirect impact is more interesting: we have a very tight labour market in the UK, or at least in most of the UK, but there does not seem to be much evidence of excessive upward wage pressure. The combination of imports, inward migration and the shift offshore of both manufacturing and service jobs seems to act as a dampener. Pressure shows up in the current account, not the inflation figures.

Are lags longer than people thought? Well, I think they may be for the simple reason that interest moves take longer to fed through into household budgets because of the growth of fixed-rate mortgages. The first chart shows how, in recent months, the rise in the effective borrowing costs for households has lagged that in base rates. But as the deals expire and fixed mortgages need to be rolled over, the effect of earlier increases in rates will start to kick in. As it does, expect consumer spending to be hit.

Consumer confidence? Well people claim to be confident (next graph) both about their own situation and, to a somewhat lesser extent, the economy. But that does not mean (third graph) people are going to rush out and spend big. Indeed, they think it is almost as bad a time for that as they did in the early 1990s.

One of the most useful concepts in economics is "revealed preference" - you don't listen to what people say they think or want. Instead you look at what they actually do - what preferences they reveal by their actions. You can apply this to all sorts of economic activities, from attitudes to taxation to international migration. Apply it to consumers and, notwithstanding their stated confidence, they seem to be pulling in their horns.

Maybe this will reverse and what we are seeing is just a pause, but in the meantime I would ignore the stated high level of confidence. Besides, there must be tax increases in the pipeline. For what it is worth, the economists at HSBC who drew attention to this data reckon that, for the consumer boom, this is not the end but the beginning of the end.

External outlook? The European growth performance is not good, but if the Monetary Policy Committee's members expected it even to be decent, they were reading the wrong newspaper. It was glaringly obvious the eurozone was underperforming and would continue to do so. It may get a mild uplift from "no" votes in France and the Netherlands on the European constitution, which could push the euro down a little, but the real benefits will take years to come through. A "no" would help the EU focus on economic performance rather than political integration and this would be very welcome - an argument developed below. But it won't help this year.

So while US performance will remain strong for the time being, the impact on the UK economy, while considerable, will not be big enough to compensate for a sluggish Europe. So the external influences on the economy are likely to be negative. More negative than one would have thought three months ago? Yes, maybe a bit, which means the Bank must be ready to offset this deterioration by ensuring that home demand does not falter for too long.

So let's pull this together and say that the balance of probability is that the next move in rates will be down, not up. If, as I think on balance is likely, the economy slows even more markedly in the next couple of months, then could a summer cut in rates come in time to rescue it?

I think the answer is yes. While one should not over-emphasise the importance of a mere quarter per cent off base rates, a change in direction - a turning point - does matter a lot. It would certainly help the housing market, which needs to be stabilised. Once people are convinced that the trend for the next couple of years will be down, they can look through any current difficulties and plan.

The obvious worry is that the Bank is still worrying too much about inflation and not enough about demand. Its guns, so to speak, are still facing in the wrong direction.

It has not made a serious mistake on the upward part of the interest rate cycle and there really has not been much of a case for lower rates until now. But it could make a mistake on the downward part of the cycle by not getting going fast enough.

Eurozone should say 'yes' to trade but not to integration

The background noise is deafening and, consequently, the signals are very hard to interpret. To judge by the volume of claims and counter-claims about the impact of "no" votes in France, you might imagine that - one way or another - the prospects for the European economy will be transformed.

Of course that is not so. A French "no" is mostly already in the market, in the sense that while the euro may fall a little, it will not decline much. Still, even a couple of cents is worth millions to European companies trying to export to the US, so anything that helps the single currency's recent modest decline will be welcomed.

The bigger influence on the exchange rate will be whether the European Central Bank actually makes a cut in interest rates, and the markets are inclining now to think that it might. But that is some way off, if at all, and will not be materially affected by the votes.

There may be some modest impact on long-term eurozone rates. A French "no" would nudge these up, for the implication would be that Brussels' central authority over economic policy - and particularly fiscal deficits - would be weakened. It is not very strong anyway, but if deficits are to run rather higher and there are more euro-denominated bonds coming on to the market, then expect rates on these to rise.

People will start also to ask whether the new member states will ever join the eurozone, which may nudge up their interest rates too.

A fall in the euro would tend to help the economy, while a rise in long-term rates would tend to hinder it. Which of these matters more? Surely the exchange rate, because low bond yield seems to have done little to boost domestic demand in recent months.

The greatest uncertainties, however, lie in the more distant future. Will Europe really respond to a "no" by focusing on economic success rather than political integration, as I hope it will? Will future relations between EU states be more flexible, so that the majority no longer try to impose their economic ideas on the minority? Will the successful economies start to have more influence on the less successful ones?

The key point, surely, is that the present EU method of co-operation between member countries has not responded sufficiently to the challenges of globalisation. As a result, the eurozone is seriously underperforming.

Somehow Europe has to learn to how to do better. That needs a change of mindset among the political leadership. Would the new constitution, if approved, encourage the EU elite to think differently? Surely not. But if it is rejected, then the leaders would have to consider what the voters really want.