Jeremy Warner: Bank acts boldly to get back ahead of the curve on rates

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The Independent Online

Outlook Rarely has the John Maynard Keynes' book of quotations been as much in demand. One of his most famous was: "When the facts change, I change my mind. What do you do, sir?" The Bank of England's Monetary Policy Committee (MPC) seems to have taken it to heart in cutting interest rates by a dramatic 1.5 percentage points. Having been slow to recognise the seriousness of the economic downturn, the Bank has acted decisively and with bravado to get back ahead of the curve. Even so, it may be a case of too little, too late.

Until yesterday, the biggest interest rate cut enacted by the MPC in its 11-year history was just 50 basis points (0.5 percentage points). Yesterday's cut takes rates to their lowest since 1955. For the first time in years, real interest rates are significantly negative (ie below the rate of inflation). The more cautious easing being pursued by the European Central Bank also means that for the first time since European currency union 10 years ago, official British rates are now lower than on the Continent.

Unprecedented times call for unprecedented action. Yet should not the Bank of England have seen all this coming a long time back and eased rates more progressively at an earlier stage? The dramatic size of yesterday's cut smacks of panic. You didn't need any of the "insider knowledge" available to the MPC to realise the UK economy is falling off a cliff. The increasingly dire news on the jobs front makes it obvious to everyone. As already announced, the economy contracted by 0.5 per cent in the third quarter. The shrinkage in the final quarter running up to Christmas looks as if it will be even worse. As for next year, the outlook is for further shrinkage still. Yesterday, the IMF forecast a 1.3 per cent contraction next year, which would make Britain the worst performing economy in the developed world. Just as worrying, the advanced economies as a whole are expected to contract by 0.3 per cent, making it the first such annual contraction of the post-war period. Parallels with the Depression of the 1930s seem less fanciful by the day.

UK house prices have already fallen by more than in the recession of the early 1990s, with little sign of them bottoming out any time soon. A full-scale collapse of the banking system seems to have been averted, but the adjustment to lending has nowhere near run its course. Credit contraction is likely to continue well into next year and perhaps beyond. The outlook for demand is bleak, with households spending less and saving more. Business confidence is also at rock bottom.

Yet it is not so much the outlook for growth as inflation which has convinced the Bank of England that it has scope to act. The Bank of England's statement yesterday put as much emphasis on the downside risks to inflation as the steadily deteriorating economy. In part, this is an exercise in self-justification. The MPC's primary remit is to meet an inflation target, not a growth objective, yet it is conscious of the criticism that it's obsession with inflation – which, by the way, it has not been notably successful in controlling either – has caused it to lose sight of the threat to jobs.

For months now, David Blanchflower has been urging his fellow MPC members to ignore prices and instead focus on the looming recession. His view was instructed by what happened in the US, where he is an academic. The US is some six months to a year ahead of Britain in the economic cycle, so he has been able to witness first hand how quickly the perceived enemy can switch from inflation to reces-sion. The Federal Reserve too was ar-guably late in recognising the change.

Economic prospects have now deteriorated so sharply that the Bank of England can justify its rates decision on the grounds that there is now a real danger of undershooting the inflation target. We'll know just how much of a danger the Bank thinks this is when it publishes its Inflation Report next week.

In any case, having initially welcomed the scale of yesterday's rate cut, markets swiftly began to worry that it was a sign of panic.

Forget recession, the spectre now haunting policymakers is that of deflation. Already we see the phenomenon in the housing market, where activity has all but dried up because of the expectation that however cheap prices are compared to where they were a year ago, they'll be even cheaper tomorrow. At internat-ional meetings, Japanese officials have been warning their Western counterparts that, to avoid deflation spreading from asset prices into the wider economy, they need to act dramatically and fast. If experience in Japan since the bubble of the late 1980s is anything to go by, once deflation takes hold, it becomes virtually impossible to get rid of, even with zero interest rates and massive reflationary spending.

There were other causes of Japan's "lost decade" besides late and ill-judged policy action, not least the political paralysis surrounding structural re-form, and the banking system's failure over many years adequately to recognise its bad debts. Both the US and British economies are relatively flexible by comparison. Nor has there been any sweeping under the carpet of the bad debt problem, which is already being brutally worked out of the system. Yet late policy action contributed in allowing the deflationary mentality to take hold. The Bank of England is scrambling to ensure it doesn't make the same mistakes. Yesterday's cut almost certainly won't be enough. Some economists already think the base rate will need to fall as low as 1 per cent, lower than at any time in the Bank of England's 314-year history.

Yet it's tricky stuff, interest rate policy. Five years ago, rates as low as this in the United States were part of the mischief that led to the credit bubble and today's banking crisis. Fighting a crisis with the very tools that gave birth to it is not self-evidently the right approach. Still, for the time being it's deflation, rather than another credit bubble, that policymakers have to worry about.

Never mind the dangers of stoking another boom. The main concern is rather that the rate cuts will be ineffective. Only around 30 per cent of UK mortgages are these days directly linked to base rates through tracker, variable-rate and discounted products. The rest are fixed rate, and although the cost of these ought to fall over time, there's no immediate impact from yesterday's change.

Even before the banking crisis, then, the mechanisms by which base rate changes are transmitted into the real economy were beginning to break down, or at least have less traction than they used to. The banking crisis has made the situation much worse. It is not so much the cost of credit as its availability which is the problem today. Policy seeks to influence what banks charge for their money through the interest which is paid on the reserves banks are required to hold with the Bank of England. Where the system has broken down is with Libor, the rates at which banks lend to one another. These rates normally track base rate closely, but spreads have widened enormously since the banking crisis began and show little sign of returning to "normality". It is possible they never will, so extreme has the reassessment of credit risk become.

The price at which banks can lend is ultimately determined by the price at which they can borrow, and right now those with cash to deposit are charging an arm and a leg for it. Banks are having to pay a whole lot more for their money, regardless of what the Bank of England may want. At the same time, they are also attempting to rebuild battered profits and balance sheets by widening the margin between lending and borrowing rates.

This is what analysts mean when they say the Bank of England has lost control of interest rates. The assertion is not quite true, as cuts in base rates will in time be reflected in relative cuts in other interest rates. All the same, rate cutting is not as effective as it used to be. At best, the effect on consumption, living standards and business activity is likely to be slow-acting, and in circumstances where there is outright deflation, rate cuts will have no effect at all. Nobody is going to borrow to spend and invest, even at zero rates of interest, if they think they will be able to buy even cheaper tomorrow.

Monetary policy is meant to act in a counter-cyclical manner. Yet it is part of the human condition that we cannot foresee the future, and most of the time policy lags rather than pre-empts the cycle. Policymakers tend to act only once the inflationary or recessionary threat is fully upon them. By that stage, it is generally too late. The extreme actions taken to dampen inflation or save the economy from depression only sow the seeds for the next boom and bust.

Still, better late than never. The Bank has certainly done the right thing by acting so boldly. Whether it will do much good is a different question. The patient is gravely ill. The possibility of the affliction ending very badly indeed in a Japanese-style deflation can no longer be discounted. The scales have fallen from the Bank of England's eyes and it is at least now sufficiently awake to recognise the threat. I'm not sure the same can yet be said about the European Central Bank.

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