Economic Commentary: It's time to keep cutting base rates

Some base rate changes leave no imprint on the memory or on the financial markets. But last week's unexpected 1 per cent decline in base rates was very different. It clearly marks an important new tack in government economic policy. Reports yesterday - since firmly denied - have suggested that the Prime Minister, overruling Treasury caution, has decided to reduce base rates to 4 per cent by the summer. If so, then good.

The Government should, however, try to sort out its message to the financial markets. Somehow, last week's move - which had been loudly demanded for weeks by most people I know in the markets - was nevertheless seen by these very same people as 'credibility-damaging' for the Chancellor. The reason is that Norman Lamont had appeared to give a clear signal in his New Year interview with the Times that no base rate cuts were then in the offing. He was quoted as saying that further cuts would occur only if growth in real GDP this year seemed likely to fall below 1 per cent. It is certainly premature to say that this criterion has been met.

The markets have therefore been puzzled about what triggered the move. In the Treasury's new spirit of glasnost, each change in interest rate policy is now accompanied by an official press release explaining why policy has been altered. The last three releases have all stated that interest rates 'are set to achieve the Government's 1-4 per cent inflation target', and have offered a litany of recent economic statistics suggesting that inflationary pressures remain low.

Unfortunately, these press releases, though well-intentioned, are rapidly being rendered meaningless. One problem is that while the official releases focus solely on inflation and other nominal variables, the Chancellor and Prime Minister speak a great deal about output, employment and other real variables. There is an increasing suspicion that the Treasury's press releases are totally ignoring the real reasons for the base rate changes.

DEEPER PROBLEM

But there is another problem. The information in the official press releases hardly seems to change from one base rate cut to the next. Nothing in particular seems to have triggered any of the last three cuts - indeed, precisely the same explanations could have been churned out by the Treasury word processor to explain much faster, or much slower, base rate cuts since sterling left the ERM.

This points to a deeper problem in the setting of monetary policy. It is well known that the full effects of a change in base rates take at least 12-18 months to come through. This means, by definition, that it makes no sense to initiate a change in monetary policy one month, and then claim a couple of months later that a further change in rates is justified because the economy has not yet responded to the first one. On many occasions in the past, this sort of behaviour has been a recipe for changes in monetary policy that turn out to be far too large.

The only sensible way to set monetary policy is to form a view of the likely behaviour of the economy a year or two ahead, and then fix interest rates to achieve inflation or GDP growth objectives over that period. At present, the Government needs to make two key decisions. The first is whether to focus mainly on generating a recovery in activity, or instead worry about the possibility that a further decline in sterling could push inflation (perhaps temporarily) above the 1-4 per cent inflation target.

The appropriate answer to this question depends on an assessment of the relative risks involved in getting policy wrong in either direction. The Prime Minister quite rightly seems to have decided that the damage that would be done by allowing the recession to deepen further (both to the long-term health of the real economy, and to the public accounts) would be much greater than any damage that might be caused by easing policy too much too soon. The latter mistake could certainly increase inflation, but any rise in prices would be slight, and could be easily controlled by tax increases (which are needed anyway to reduce government borrowing), or by reversing the base rate cuts later.

This means that, contrary to the language contained in the Treasury's press releases, policy should for now be aimed mainly at maximising the chances of economic recovery. The next question is the level of base rates needed to do this. Is 6 per cent low enough? Obviously, nobody knows for sure, and because of the time lags mentioned above, the recent behaviour of the economy offers little guidance. But two considerations seem relevant.

The first is that experience in other highly indebted economies - notably the United States and Australia - indicates that base rates might need to drop a long way below 6 per cent, and stay there a long time, to generate a decent recovery. The second is that the level of real interest rates is still quite high, given the worrying overhang of private sector debt in the economy.

REAL RATES

The graph shows the level of real short-term interest rates in Britain and the US since the 1920s. Real base rates in Britain are still well above 3 per cent, and because of widening spreads in the banking industry, the real borrowing costs facing the private sector are considerably higher. This level of real interest rates remains unusually high in a long-term historical context - look especially at the 1930s - and is certainly much higher than the levels of real rates that eventually triggered recovery in America.

There are other compelling reasons for pushing interest rates as low as can be managed without totally unhinging sterling. One relates to the looming increase in the Government's borrowing requirement. Somehow or other, the Government will need to sell pounds 50bn- pounds 55bn worth of gilts in the coming year, roughly twice the amount sold last year. The best way of helping this along is to make the return on bank and building society deposits highly unattractive, thus inducing individuals to move into gilts to pick up yield. Furthermore, a relatively low exchange rate would certainly help to suck in some foreign buying of gilts.

The other key factor is the need to 'recapitalise' the banking sector. If the high street banks were forced today to 'mark to market' the true value of their loan portfolios, we would not see a pretty picture. Fortunately, the banks will not be forced to do this, any more than they were forced to 'mark to market' the true value of their Third World loan portfolios in the early 1980s. They will be allowed to work themselves out of their problems gradually, using their operating profits in the next few years to offset loan provisions.

However, while this process is under way, the banks will be extremely reluctant to lend on anything but the most secure projects, and this unusually high degree of risk aversion could slow the recovery. Lower interest rates will speed the 'work out' process by allowing the banks to increase the spreads on their lending business.

All in all, this surely makes a compelling case for following the Prime Minister's reputed instincts, and cutting base rates further - despite the fact that sterling is now most certainly in for a very grizzly period indeed.

(Graph omitted)