Take them down another notch: Bill Robinson argues for a further cut in interest rates to shore up a faltering recovery

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The Independent Online
FOR some time, the talk of City lunch tables has been the need for a further cut in interest rates. The City wants an easier monetary policy because the stock market has, after the heady rise that followed our exit from the ERM, been showing signs of weakness. The real economy has also been flagging. Recent surveys of business opinions have revealed a much less upbeat mood, with order books shorter and new orders down at home and abroad.

None of this cuts any ice with the Treasury, which is concerned above all with the 1-4 per cent inflation target. As an ex-insider, I am often asked why the Treasury has not moved sooner to cut interest rates. In the summer the answer came in two parts. First, the Government saw serious risks in easing policy, since it was still very concerned that inflation would nose above its 4 per cent target next spring. Second, it saw no need to ease, since the recovery seemed to be progressing satisfactorily without official assistance.

But as summer turned to autumn the recovery lost some steam. So why didn't the Treasury act? When asked this question, I tended to give the cynical answer: of course the Government wasn't about to cut interest rates in September or October, when it had a Budget at the end of November. Since it would probably be announcing further tax increases in the Budget, it was bound to save up any interest rate cuts for then, to sugar the pill.

That was the conventional wisdom among seasoned Treasury watchers and I was surprised by last week's announcement of a half-point cut in interest rates. It was, however, a pleasant surprise, not least because the Treasury has signalled a new, better way of doing business. When an interest rate cut is in the offing, the internal discussions come in two parts: economic and political/market. The first question concerns the inflation prospects on present policies. How would they look if policy were eased? What is happening to the various measures of money supply, to house prices, to the exchange rate?

On the basis of this evidence, a decision is taken to cut interest rates. The discussion then moves to the political and market dimension. If interest rates are to be cut, when is the best time to do it?

In my time in the Treasury I found that economists could contribute much to the discussion on whether rates should be cut but little to the discussion on when they should be cut. Even three months is a short time in economics, so if the Government decides to cut interest rates this quarter it doesn't matter in the slightest whether it happens tomorrow or on Thursday fortnight.

However, we all know that a week is a long time in politics, and an hour can be an age in the financial markets. Since interest rate changes have a political dimension and a market dimension, much mystique surrounds the precise timing of cuts. Should we go tomorrow, to prepare the ground for the Chancellor's speech in the House next week? Or should we wait a few days to get maximum impact the day before the speech? Are the markets expecting a cut? If not, will they conclude that it is politically motivated and react badly? Could they be prepared if we waited a few days?

Personally, I always found these discussions incomprehensible. Was this because I lack some essential faculty, like the tone-deaf man at a concert? Or was I more like the little boy who sees that the emperor has no clothes? On balance, I believe the new arrangements, which delegate the decision on the timing of interest rate cuts to the Bank of England, will spare the Chancellor and the Governor many hours of unproductive discussion. The Bank will be free to ignore the politics and time interest rate changes so as to minimise the windfall gains and losses to market participants. The Chancellor will be encouraged to focus on the strategic economic question, to ease or not to ease, undistracted by short-term political considerations that might otherwise cloud his judgement.

On the strategic issue itself, all the arguments point to the need for further easing. All the recent evidence, anecdotal and statistical, suggests that inflation is turning out lower than was officially forecast at Budget time. The second reason why last week's cut was welcome was that it showed that the Treasury recognises this.

The most astonishing development is the continued fall in wage inflation. A year after our exit from the ERM, which saw the exchange rate fall by 15 per cent, wage settlements are still falling and have reached a record low of 2.5 per cent. In the year that followed the 1967 Wilson devaluation, also of 15 per cent, wage inflation rose by nearly 5 per cent. The contrast between these two episodes shows how powerful are the underlying disinflationary forces at work in the economy at present.

Falling wage inflation will ultimately help the recovery because it will make us more competitive. But over the next few months the economy must negotiate an awkward corner. Headline inflation will rise as last year's interest rate cuts drop out of the Retail Price Index, and that, together with the tax increases announced by Norman Lamont last March - plus any further increases that Kenneth Clarke imposes today - promise very slow growth in real income.

This means that the continued recovery of consumer spending next year depends almost entirely on people saving less. If you look closely at the forecasts of the Seven Wise Men who advise the Chancellor on the economic background to his first Budget, it is striking how much of the recovery next year depends on continued confidence - of consumers, who are expected to increase their spending even though their incomes will not be growing, and of businesses, which are expected to invest in spite of obvious worries about the state of demand abroad and at home.

Confidence is faltering, but the Government can restore it by cutting interest rates. Last week's cut was a step in the right direction, but we need a lot more of the same to maintain the momentum of a patchy and flagging recovery. The tax and spending decisions announced today will ultimately be judged on their success in paving the way for the aggressive easing of monetary policy that the economy now needs.

The author was a special adviser to the former chancellor Norman Lamont and is a director of the consultancy London Economics.

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