Jeremy Warner's Outlook: Rates dilemma should be settled by a cut

Big, bad banks turn screw on customers; Rock shareholders gamble over vote
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The Independent Online

If the Bank of England is sooner or later going to cut interest rates anyway, it might as well get on with it and cut them further right now. Yet that's not where the smart money is ahead of this week's meeting of the Monetary Policy Committee. Most City economists think the MPC will wait until February.

We've only just had a rate cut, they point out, and the Bank normally likes to wait until just before publication of the quarterly inflation report before taking monetary action. The next one is in February. The economic news flow since the last rate cut has been unremittingly gloomy, but not devastating.

What's more, inflationary pressures have if anything grown further. The pound is weaker, making imports more expensive, energy prices are once more going through the roof and there has been a marked pick-up in above-inflation pay settlements.

Approximately a quarter of all settlements are struck in January, with most of the rest occurring by the end of April. Moreover, they tend to be determined not by reference to the Consumer Prices Index, but the RPI, which in November hit 4.3 per cent.

As a rule of thumb, the Bank of England has said it is not until earnings rise by 4.5 per cent or more being inflation plus 2 per cent for productivity growth that the alarm bells begin ringing. With private sector pay settlements running at 4 per cent, we may be getting towards that point after bonuses, promotional increases and the like are taken into account.

Disposable incomes are now being quite severely squeezed by the effect of higher interest rates, taxes and inflation, making employees more than usually demanding in their pay negotiations. The spectre of unemployment has yet to feature as a significant deterrent. The Government is also on a collision course with workers over public sector pay.

In other words, the case against a further immediate cut in interest rates is easily made. This is more particularly the case as we have had these recession scares before, and in the most recent instances they have turned out to be wide of the mark. In the autumn of 1998, for instance, every man and his dog was saying there was going to be a recession. The view was much more unanimously held than it is today.

Even the Governor of the Bank of England, Mervyn King, was prevailed upon unwisely to predict there was a 25 per cent probability of recession. Much the same thing happened after 9/11. Yet on neither occasion was there in fact a recession in the UK.

Personally, I've been more optimistic than most about prospects for the economy this year. Like Sir Martin Sorrell, chief executive of WPP, I'm more concerned about what happens the year after with a new president in the White House, and the Chinese, post the Beijing Olympics boom, struggling to address some serious structural issues within their economy.

Even so, I'm in the camp that thinks interest rates should be cut sooner rather than later. Looking at the progression of UK monetary policy, we see interest rates rising as prescribed in the early part of last year to choke off an economic boom that was beginning to run out of control.

This gentle application of the brakes would in all likelihood have produced the hoped-for soft landing but for two events the credit crisis and now, to add further misery to the cocktail of negatives, an oil price shock on top. The effect of both these happenings is proving more serious than originally predicted.

For the time being, the Bank needs to set aside its concerns about inflation, and provide the necessary stimulus. There are lots of perpetual gloomsters out there gleefully looking forward to the economic Armaggedon they have for so long predicted, but actually most of us just want stable employment prospects and a nice life. The Bank should be doing all it can to underwrite these modest aspirations.

Big, bad banks turn screw on customers

Even if the Bank of England does cut interest rates this week, it is asserted in some quarters, it's not going to make a great deal of difference because the credit crisis is now so entrenched that the evil high street banks won't pass on the benefits. There is already some limited evidence of them playing this game. Nationwide and HBOS were the only major lenders immediately to pass on the full amount of the last rate cut. Most others dragged their feet and a few have yet to pass on the full benefit.

On the other side of the ledger, deposit rates were immediately cut by the full amount and in some cases by more. This assertion might seem at odds with the very competitive rates some banks are offering for new deposits. Yet these rates are not by and large offered to existing depositors unless they take active steps to take advantage of them.

The antidote to this kind of behaviour is obviously for depositors to vote with their feet and chase the higher-paying accounts. These days it is not difficult to switch. Yet continued customer inertia when it comes to financial services means that, with the exception of an always promiscuous minority, banks can generally be confident that their depositors will just grin and bear it.

As I say, evidence of sharp practice has so far not been that bad, yet it is quite likely to get a great deal worse come the next rate cut. HBOS said in its trading update that abnormal conditions in the money markets which have kept Libor well above bank rate for most of the past six months added 60m to its funding costs in the second half. Bankers already reeling from heavy write-downs on mortgage-backed securities and private equity debt are bound to try and recoup these extra funding costs from their customers.

Even so, they had better watch out. Bank bashing is now back in fashion. We have already seen the Liberal Democrats demand the Cruikshank proposal s for fully fledged regulation of bank charges and profits be dusted off and implemented. If banks expect their lending to be underwritten by the taxpayer when the going gets tough, as has occurred with Northern Rock, then they must also accept a greater degree of public control. This is a view that may be dangerously mistaken, yet the banks hardly help themselves by making the customers pay for the consequences of follies they themselves have created.

Rock shareholders gamble over vote

Ever since it became apparent last July that Northern Rock was struggling with its funding, investing in the shares has been a high-risk gamble. Most have lost a lot of money by doing so. Now the company's two biggest shareholders, both hedge funds and both quite recent investors, are seeking support for resolutions that would impose severe restrictions on the management's ability to make disposals or raise new capital without seeking shareholder support first.

This too is a gamble. To hedge funds, the Northern Rock board has come to look more like the stooge of the company's biggest creditor, Her Majesty's Treasury, than directors who properly represent the interests of shareholders. They naturally fear that these interests are about to be sold down the river. The board in turn is worried about doing anything that upsets the Treasury and provokes the very nationalisation that everyone wishes to avoid.

The Treasury for its part worries that if the resolutions are passed the shareholders will obstruct all deals which impose any kind of a haircut on them. As ministers see it, the taxpayer is carrying all the risk of further deterioration at Northern Rock while at the same time being excluded from the upside of any recovery. The Treasury takes the pain, the shareholders take the gain. If the Rock were nationalised, the taxpayer would get the profits for little if any extra risk.

Even so, I can't see that shareholders have anything to lose by voting in favour. By doing so, they seek only to avoid the imposition of a deal which would largely wipe them out. Even nationalisation might be preferable to such an outcome, as, in any nationalisation, it would be hard for the Government to avoid the payment of compensation.

j.warner@independent.co.uk

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