Jeremy Warner's Outlook: Limited options for Mervyn King on rates

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The Independent Online

At 2.1 per cent, Britain's inflation rate for October was as close to target as it is possible to get without actually hitting it. Yet it was higher than the previous month's 1.8 per cent and also a bit higher than the City was expecting. If the rate of inflation is higher than target, even if only a tiny bit so, it plainly makes it more difficult for the Bank of England to cut interest rates.

We'll learn more about the Bank's intentions today, when the latest quarterly Inflation Report is released. The big change since the last one is, of course, the credit crunch, which will in time cause growth to slow markedly. The Treasury has already cut its forecast for the economy next year. The Bank of England will surely follow suit.

With credit conditions tightening and domestic demand as a consequence abating, this ought in itself to reduce inflationary pressures. House prices are now quite obviously falling, reducing the propensity of consumers to spend, while the fall-off in activity in the City is also plainly going to have adverse consequences across the economy. Yet at the same time, there are still inflationary pressures coming through. Some of these are temporary. For instance, the crop destruction caused by the summer floods is likely to cause continued upward pressure on seasonable vegetable prices. But others are more structural. Rapid growth in Asia is putting a rocket under energy and commodity prices.

As we now know beyond any doubt, Mervyn King, the Governor of the Bank of England, is something of a puritan in his stance on both monetary policy and moral hazard, as well as quite stubborn in his views. Despite all the criticism he's come in for over Northern Rock, it seems unlikely he's experienced a Damascene conversion and now stands ready to cut rates so as to support markets and growth. Only if he sees the inflation danger subsiding will he be persuaded of the merits of such action.

This is in most respects as it should be. Less than six months ago, many sectors of the UK economy were boiling over with activity. The slowdown now being experienced is a necessary corrective. In time, commentators may also reflect less harshly on the Governor's hard-nosed approach to the credit crunch.

Part of the process of economic renewal is that bad debt should be recognised, written off and sold on. If policymakers take steps to stop this catharsis from happening, it not only creates moral hazard, encouraging the whole merry dance to begin afresh, but it is also capable of generating economic stagnation, as occurred in Japan during the 1990s.

Refusal to acknowledge the banking system's bad debts had the effect in Japan only of subsidising rotten companies and investment, thereby stifling the development of new enterprise.

The market's pricing mechanisms have to be allowed to do their work, however painful it might be. That's why plans in the US for a super-SIV that would buy up distress sales of mortgage-backed securities in the hope of putting a floor under the price seem flawed. To work properly, markets have to be allowed to mete out their punishment.

China's threat to BHP's mining merger

There doesn't seem to be any room for the middle ground when it comes to investment attitudes to the mining sector. People are either extreme bears or extreme bulls. Both make an entirely plausible case.

For the bulls, Chinese and Indian development will drive growing demand for commodities for years to come. In setting out its plans for bidding for Rio Tinto this week, BHP Billiton pointed to exponential demand growth. The company's chief executive, Marius Kloppers, is a fully signed up member of the "super-cycle" club.

The bears see the excitement that surrounds Chinese and Indian growth as just the dotcom bubble in new form. To them, the BHP Billiton bid for Rio looks the same as the Vodafone bid for Mannesmann, or the Time Warner merger with AOL, both deals that came to mark the pinnacle of the technology boom.

There is obviously a bit more substance to what's happening in the mining industry. For starters, the boom in mining shares is based on a similar surge in sector earnings. The dotcom valuations were based on hope and fantasy alone. There is also no doubt China and India will continue to grow rapidly.

Yet there is scope for plenty of bumps along the way and therefore interruptions in the "super-cycle" before finally it reaches its zenith. Whenever there is a boom, there's also a supporting cast of cheerleaders to explain why this time it will be different, allowing the expansion to persist into the indefinite future. It never does, of course.

In the meantime, the sun still shines and the miners continue to make hay. The biggest threat to BHP's bid for Rio, it was being pointed out at one City breakfast table this week, is not so much regulatory obstruction as that the Chinese will refuse to accept any safeguards the anti-trust authorities might offer and instead act to frustrate the merger themselves by acquiring a blocking stake. This would be the worst possible outcome for producers, and, for Australia – where the great bulk of the two companies' iron ore comes from – it would be a much more worrying turn of events than the creation of a BHP/Rio colossus. With the customer controlling the producer, China might be able to drive down prices to its own advantage.

One thing is certain. Any Chinese intervention wouldn't be driven by the normal investment priority of value enhancement, but rather by strategic, national considerations. This would be all the simmering concern about the growing power of sovereign wealth funds writ large, and might even provide the trigger for the entire sector to tumble out of bed.

Bankers forced to go in search of capital

Please don't call it a rescue rights issue, but, with the credit crunch still very much in evidence, a whole slew of Western banks, possibly including our own Royal Bank of Scotland, will have begun looking at ways of bolstering their capital reserves.

After a raft of cash acquisitions in recent years, some British banks appear more leveraged than their American and European counterparts. With core tier 1 capital at 4.25 per cent of assets, RBS's ratio is already tight. Big write-offs in respect of asset-backed securities might further erode the margin for error. Over time, cash flow ought to rebuild these reserves of their own accord. Nobody should believe that RBS and Barclays are in any difficulty or peril. Nonetheless, after such a fright, the pressure will be on from banking supervisors urgently to address the problem of diminished capital. More equity isn't the only way to go. The issue of long-dated debt securities might achieve the same result.

All the same, any capital raising would be hugely embarrassing for Sir Fred Goodwin, chief executive of Royal Bank of Scotland. He staked his reputation on forging ahead with the capital-intensive ABN Amro takeover despite the gathering credit crisis. Now he'll have to suffer the consequences.

Farcical sales process for Northern Rock

The Northern Rock sales process descended into farce last night with Northern Rock seeking to injunct the Financial Times against publication of a sales prospectus which the newspaper had already largely regurgitated on its website.

What is embarrassingly clear from the briefing memorandum is that there is no contemplated disposal which would get the taxpayer off the hook for the £24bn of public money which has so far been lent to the Rock. As proposed, there seems to be no prospect even of a sale as a going concern, let alone one that would offer the Treasury a clean exit.

Yet the Government still washes its hands of the sales process, preferring instead to leave the fate of all that public money in the discredited hands of Adam Applegarth, Northern Rock's chief executive. The whole thing is quite bizarre.