Commentary: Slump more of a danger than inflation

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The Independent Online
The Chancellor is right to cut bank base rates to 6 per cent. After last week's gruesome indicators for jobs, unemployment, manufacturing output and retail sales, Norman Lamont appears to have decided that there was a risk of a sharp jolt to business and consumer confidence if he did not act. With luck, he will take the logic of that assessment further with yet another cut in short order. The prime risk is not inflation but continued slump.

The Treasury has consistently underestimated the strength of the deflationary forces in the British economy. When the pound was within the exchange rate mechanism, the Government failed to use its tax and spending policy as actively as it should have done to bolster activity. It paid the price when the markets decided that it could not afford to defend the pound by raising interest rates. Outside the ERM, the Government has been slow to grasp its increased freedom of movement on interest rates.

As Nigel Lawson once pointed out, the Treasury either does too little, too late or too much, too late. But there may also be a tendency to misapply some of the lessons of the Eighties. When banks and building societies were unleashed on each other in free competition after 1980, the right course for monetary policy was to keep real interest rates (after allowing for inflation) unusually high. Despite real interest rates at roughly double the historical long-run average of 2.5 per cent, mortgage lending still grew far too rapidly for the health of the economy.

But it does not follow that real interest rates have to continue to be kept high. Indeed, the Eighties' legacy of personal and corporate indebtedness implies that it is appropriate for real interest rates to be lower than they would have been without the debt build-up. Financial market liberalisation implies higher interest rates in booms, and lower ones in busts. In an ideal world, real interest rates should now barely be positive.

Yet real bank base rates are 2.3 per cent - 6 per cent minus 3.7 per cent underlying inflation (excluding the impact of recent mortgage rate cuts, which artificially reduces the 'headline' rate to 2.6 per cent). This is much higher than real rates of 0.4 per cent in the US, where the Reagan-Bush era has bequeathed comparable debt burdens. Given the patchiness and sloth of the US recovery, there is a strong case for arguing that Britain's interest rates are still too high.

Moreover, the rates actually paid by British borrowers have not come down as rapidly as bank base rates. Although the Bank of England yesterday exonerated the clearers from failing to pass on base rate cuts to small businesses, the story for mortgage borrowers is very different. Halifax, for example, announced yesterday that its mortgage rate would fall by 0.55 percentage points to just under 8 per cent: a real rate of 4.3 per cent.

A widening of bank and building society spreads - the excess of interest rates charged to borrowers over the cost of funds to the lender in the money markets - is an inevitable response to bad property and other debts. The cavil is not with widening spreads in themselves but with the fact that interest rates are still not yet low enough to allow both borrowers and lenders to rehabilitate their battered balance sheets at a reasonable pace.

The markets reacted sensibly to the rate cut, though bemused by the timing. (The Bank probably advised that it was better to cut after a day of sterling strength than last week's weakness). The pound was off little more than 1 per cent on its trade-weighted index, and is still higher than its November average. Gilts rose because the markets decided they would be more attractive than cash, which should help the Government finance its borrowing requirement. All in all, the Chancellor should move further before long.