Outlook: UK interest rates

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WILL THE prospect of mince pies with tea tomorrow and Thursday make members of the Monetary Policy Committee play Santa and cut interest rates this week? If they don't, the nation will feel Christmas has been cancelled. So should they make it an extra-special Xmas and cut by a half-point or more? Or should they play Scrooge? Short-term interest rates in Britain are now some of the highest in the developed world, so the debate is no longer about whether rates should fall, only about how much and when.

With the latest figures and surveys gloomier than ever, the notion of a big reduction to prevent the economy sliding too far, too fast has a lot of appeal. The case was put by Willem Buiter at November's MPC meeting. He argued that it would provide some insurance against inflation falling below its 2.5 per cent target - the risk in a year or so's time. Furthermore, it would fortify business and consumer confidence at a time when they were diving. Finally, it would be better to cut rates as far as they would probably have to fall in one swoop, rather than making a series of little reductions.

In a recent speech another MPC member, Charles Goodhart, reported that central banks are in real life far less activist than they ought to be in theory. In theory, a surplus of news about the economy one way or the other ought to tilt the balance; we should expect to see lots of rate changes, and lots of reversals.

In practice central banks are far more cautious. They rarely change the direction of policy, and when they do, it is to move in a series of small steps. Big changes in interest rates are the exception.

Professor Goodhart reckons that this is partly because commentators always criticise a big shift in policy. When the MPC raised rates unexpectedly in June, it was described as "laughable" and accused of dissipating its credibility. Central bankers are only human, and they are sensitive about these things.

But it is also partly because of pervasive uncertainty about the state of the economy. The data is uncertain - witness the suspension of the average earnings figures and the normal size of revisions to GDP. The way the economy works is uncertain too and it is uncertainty - driving through thick fog, using only a rear-view mirror with steering that responds with a two-year lag - that justifies moving rates in small steps.

That said, nobody would much mind the MPC getting it wrong now and cutting interest rates too much. Inflation might rise above target but we all enjoy an expansion. But just think of the uproar if it had raised rates by three-quarters of a point in one go last year. We would all have been pretty uncertain about whether the economy needed that medicine. Professor Goodhart's preference for small doses is probably the right one, and it is the one most likely to be adopted at this week's meeting of the MPC. The debate will rage on, all the same.