Hamish McRae: I've changed my mind: the Bank must lower interest rates if we are to avoid recession

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The Independent Online

We are at a turning point. It is one of those rare moments in economics when you know that the next few months will feel quite different to the past few ones. We are clearly at a turning point on interest rates, with an odds-on chance that the Bank of England will cut them tomorrow.

We are equally clearly at a turning point in the housing market for, according to the Nationwide, house prices last month had their biggest drop since 1995 and further falls seem almost inevitable. And rather less clearly we are at the beginning of some sort of slowdown in our own economy, though just how serious remains to be seen.

To see what is happening, the best place to start is to look at the need for that cut in interest rates. Until a week or so ago I felt it would be better to wait. The economy is still growing well, companies are optimistic, and on the other side of the equation, inflation remains a worry. But I have changed my mind. It may be that the Bank's monetary committee will postpone the first reduction until next year, but I am now sure that to do so would be a serious error.

The reason is that there has in recent weeks been a sharp and unexpected increase in interest rates in the financial markets, despite the no-change policy of the Bank. Under normal conditions the Bank's interest rate determines all short-term interest rates. However, since the late summer, and particularly in the past few days, a gap has opened up between rates on the money markets and the rate set by the Bank.

You would expect money market rates to be a bit higher than the Bank's rate, but not much: perhaps one-tenth of one per cent. Well, yesterday, with Bank rate at 5.75 per cent, the one-month money market rate was just under 6.75 per cent. So any bank that relied on the money markets as opposed to retail deposits would be in trouble.

That is what undermined Northern Rock, for it had few branches and so relied more than any other mortgage bank on money markets. When the word got around that it was under pressure on the money markets, ordinary depositors took flight too.

It is not just our banking system that has this problem; the same is happening in the US and on the Continent. Banks all around the world are unsure of the value of some of their loans, a fall-out from the US sub-prime debt crisis, with the result that they are hoarding cash. Any spare cash would, in normal conditions, be lent to other banks via the money markets but because they are so worried they are putting any spare into ultra-safe things such as short-term government debt. The strong banks are fine; the weaker ones are not.

You can have two reactions to this. One to say that the bankers were stupid and greedy and they deserve to be kicked in the teeth. The polite way of putting this is to warn of "moral hazard". The other is to say that, if the bankers become so frightened they won't lend any money, the whole economy gums up and that is worse for all of us.

The initial reaction of the Bank of England, perhaps to a greater extent than the US Federal Reserve and the European Central Bank, was to stress moral hazard. But then none of the top three people in the Bank are bankers. Now a more balanced response seems to be evolving. While a cut in interest rates would not solve the problem the availability of finance, not just the price it would help a bit.

The practical point here is that, until a month or two ago, neither home-buyers nor companies had any difficulty getting loans. But now the flow of new mortgages is declining, while companies may find it hard to renew their full lines of credit when these come up for review. Marginal borrowers, such as people who want to borrow 100 per cent of a property, and weaker companies may find credit shuts altogether. If banks can't rely on the money markets to fund themselves they have to cut back on their lending. It is as simple as that.

So what will this do to the housing market? The US market is now in a dire state, with prices falling month by month. David Miles, economist at Morgan Stanley, predicts that prices here will fall by 10 per cent next year and there have been calculations that our prices are anything up to 40 per cent over-valued.

The most authoritative prediction comes from the markets, for there is an actual market on which you can bet on a fall, or hedge against one. That suggests prices will fall by 7 per cent in money terms, more in real terms, next year. But it is hard to see anything worse than the early 1990s housing slump and, given the fact that the falls then were the result of having too-high interest rates, the balance of probability is that the downturn in house prices will be less serious.

What might make things worse would be, of course, a recession, something we have not experienced since the early 1990s. One obvious trigger would be the housing market. A lot of people with large mortgages would cut back their spending, the economy would slow and some people would lose their jobs. That would worsen the housing market, particularly if even a small proportion of people became forced sellers. But is recession really likely?

For the US it is quite possible, but I think the balance of probability in the UK is more for two or three years of much slower growth, with 2009 being more of a worry than 2008. At the moment our economy is still growing strongly, companies are buoyant, and it always takes quite a while for any slowdown to move through the system. We are not in as big a mess as we were in during the early 1990s, for the 1980s boom was more marked and we are not now obliged to keep our interest rates in line with European ones as we did when we were part of the exchange rate mechanism.

On the other hand, we are not in as strong a position as we were in 1999, when our public finances were in surplus, and when rising public spending (and borrowing) could offset the global slowdown. In fact it looks as though the fiscal deficit this financial year will be above 40bn, even higher than the (upwardly revised) 38bn the Chancellor announced in October.

My instinct is that the forthcoming downturn will for Britain be somewhere between the early 1990s one, which was quite serious, and the early 2000s one, which for the UK at least was hardly a downturn at all. The problem is that the ability of the authorities to offset any decline in demand, either by monetary or fiscal policy, will be more limited than it was last time.

Cutting interest rates does help a bit but the difficulty will be availability of credit as much as the price; and we are close to the acceptable limits of government borrowing. Not a lot of ammunition in the locker: it would be nice to have more but it is a bit late for that now.