Hamish McRae: Lower interest rates are no magic bullet, but given time they will work

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The Independent Online

Another month, another Bank of England Monetary Policy Committee meeting – and another interest rate cut? Well, we will learn today, but if we don't get a quarter-point now, expect it to come through in June instead. The path is clearly down, with rates at 4 per cent by December now on the cards and maybe even lower.

That leads to two questions. Has something changed in the economic outlook that makes this decline in rates more urgent, despite still-high inflation? And what effect will lower rates have on the economy?

As usual the signals are mixed, but there do seem to be more suggestions that it will slow progressively through the rest of this year. The very latest estimate for growth comes from the National Institute for Economic and Social Research, which does a monthly running calculation of GDP figures. It says that growth in the three months to end-April was 0.4 per cent. Multiply that by four and you get 1.6 per cent, but that is too precise; better to say that growth is running somewhere between 1.5 per cent and 2 per cent, which is where most of the unofficial forecasts are for the year as a whole.

If that is where we end up, it would be fine. It would be an orderly slowdown, which is what the Bank of England would argue that we need to correct the various imbalances in the economy. The danger is that something worse might occur. On this count, there were some discouraging figures on industrial production yesterday, a fall in March when production was previously expected to be flat (see first chart). There had previously been some weak forward-looking numbers from the service industries (next one). Put the two together, and you might be looking at growth towards the bottom end of present predictions, not the top, but it would not be right to claim that it was falling off a cliff.

What does seem to be falling off a cliff is the housing market. As everyone knows we now have a small year-on-year decline in prices, but that conceals six months of gains and six months of losses. Look at prices on a six-month basis and prices are falling at an annual rate of around 9 per cent. Look at them on a three-month basis and annualise that, and the number for the Halifax index is minus 15.7 per cent. Those of us who expected either a plateau in prices or modest declines look like being wrong. Amex Bank now expects prices to fall by 20-30 per cent from their peak last summer over the next three to four years.

Whether or not that proves to pessimistic (or optimistic, depending on your viewpoint) the idea that we should be thinking about a subdued housing market for the next three or four years rather one or two feels right. We are unlikely to see the evictions that occurred in the early 1990s because we will not see the very high interest rates we had then, nor in all probability the surge in unemployment. But we will see negative equity come back; in fact, that is starting to occur now. That will squeeze consumption. Worse, our discretionary spending – what we would like to spend money on, rather than what we have to – will be squeezed by the combination of higher fuel and food prices, and higher taxation.

This has obvious political consequences: the Prime Minister will want to play this as long as he can in the hope that the something (ie, the economy) turns up. But for most of us, the politics are less important than the economics, for the latter has a much more direct impact on our lives. The big question there is the one posed above: what effect will lower interest rates have on the economy?

It is important to make a distinction between the housing market and the economy as a whole. Do not expect the odd quarter percentage point off rates to have any noticeable impact on house prices. If prices are falling at, say, 10 per cent a year, being able to borrow at, say, 5 per cent instead of 6 per cent will not make people rush to the estate agents. For the housing market, the availability of mortgages is more important than the cost. The supply of mortgages will be tight for several years, and it may be a decade before we see 100 per cent mortgages freely available again.

Cuts in rates, however, are not intended to rescue house prices; they are to rescue the economy. A fall of one percentage point in mortgage rates would add over a year, on my back-of-an-envelope calculation, about 0.25 per cent to family budgets. That could either go into consumption or be saved. Roger Bootle, writing in the Deloitte Economic Review, reckons that there will be quite a painful adjustment in household spending, not as serious as the early 1990s, but painful nonetheless. But then we have over the past decade experienced the fastest growth in overall demand of any of the major developed economies, as the bar chart shows. The three or four slim years would follow a decade of fat ones.

Lower interest rates help in several ways. They give the direct boost to household budgets noted here. They also reduce borrowing costs for business. They help to reduce the level of sterling, which makes exports more competitive and imports less so. So there is pressure to switch towards home production: you are working on both the production and demand side of the equation. It was the fall of sterling after it was ejected from the ERM in 1992 that laid the basis for the long 16-year boom that now is drawing towards an end.

True, even cheaper money failed to pull Japan out of a decade of stagnation in the 1990s and early 2000s. But the UK in 2008 is not Japan in 1993. Our property boom has been less extreme; our currency is less over-valued; and given the opportunity, our consumers are less timid. While I don't think any of us should regard low interest rates as a magic bullet, given time they will boost demand.

The final question, then, is how much freedom the Bank will have to cut rates. It has to meet its narrow objective of keeping inflation close to 2 per cent, but it also has to maintain overall financial stability. That may not be a statutory mandate but it is an historic one: for a century and a half that has been an important role for central banks. You could argue that over the past 11 years it succeeded in its narrow task, but failed in its wider one. The formal mandate on the Bank will presumably be changed in the next couple of years when the next government takes office, and I would expect that to encompass financial and economic stability in some form. But meanwhile, provided it can make a reasonable case that it is not downplaying its present duty on inflation, it has quite a bit of leeway to cut rates if the economy needs it. So expect lower interest rates, whatever happens today, but be patient. They are a powerful weapon but a slow-acting one.

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