Jeremy Warner: Don't expect interest rate cuts to deliver wondrous results

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Outlook He may have been only stating the blindingly obvious, but when the Bank of England Governor Mervyn King opens his mouth, markets tend to sit up and listen. His comments the other night admitting the probability of recession have further poleaxed sterling and the stock market in equal measure.

Most criticism of the Bank has focused on its apparent failure to recognise the seriousness of the economic downturn at an earlier stage with pre-emptive policy action. Personally, I don't think this is fair. Just two months back, the predomin-ant worry was still inflation. Since then, the banking crisis has got much worse, removing all hope of the once anticipated soft landing. Criticism of monetary policy should rather focus on much further back when, far from being too high, interest rates were arguably far too low, allowing the credit boom to get out of control.

This was as much the Government's fault as the Bank's. The Bank was required to meet an inflation target which took no account of house prices and mitigated what were plainly quite high levels of domestically generated inflation, particularly in services, with the imported price deflation of goods from Asia. But again, it is easy to forget that the period that gave birth to this low interest rate environment, both in the US and Britain, was one in which deflation, rather than inflation, was the primary concern.

It is part of the human condition that we are condemned to see the future through the prism of past and present. Monetary policy, which is meant to act in a counter-cyclical manner, is no different in this regard. It tends to lag, rather than lead, the cycle. In any case, with the economy now falling off a cliff, Mr King seems to have forgotten all hawkishness and stands ready to slash interest rates in an effort to sustain demand. Unfortunately, such action will take quite a while to have any effect. Even in normal times, interest rate changes take a year or two to gain traction in the economy. In today's abnormal con-ditions, they may take even longer.

Yesterday, GDF Suez, the French utilities goliath, managed to raise £500m in the sterling bond market. This is an encouraging sign in some respects of the promised thaw in credit markets, as even a few weeks back it wouldn't have been possible. Yet if even a company as creditworthy as GDF has to pay as much as 7 per cent for 20-year money, then we are indeed living in a changed world.

Cuts in official interest rates may not help the real economy much when it is the availability of credit rather than its cost which remains the problem. What they might do, however, is provoke a full-blown sterling crisis, which would ultimately be inflationary and therefore cause rates to rise again. The Bank may have no option but to slash rates, but it is a strategy fraught with potential downsides. Monetary policy cannot be relied upon to deliver economic salvation.