Thursday, 6 December 2007

The Bank of England cuts interest rates - part 2

Whatever counterinflationary credibility the Bank of England might have had, it lost it today. Their decision to cut interest rates while inflation is above the 2 percent target was utterly irresponsible. The retail price index, the most valid measure of inflation, is currently at 4.2 percent. This is an unacceptably high.

Furthermore, there is plenty of evidence that inflationary pressures are rising; food prices are increasing; world commodity prices are at all-time highs, while gas prices are scheduled to go up by 15 percent in January. Rather than cutting interest rates, the Bank of England should have increased them.

So why did the Bank of England feel it necessary to throw caution to the wind and cut rates today? Their own press statement hints at two explanations; bailing out housing speculators, and protecting the Banks.

After years of double-digit price growth, the housing market suddenly felt the cold winds of reality. Prices are now falling and the Bank of England fear that the collapsing housing market might take consumption and ultimately growth down with it.

However, the Bank of England were quite happily to facilitate the housing bubble with low interest rates throughout most of this decade. When confronted, Bank of England staff would say "it is not the responsibility of the central bank to target asset prices." When mortgage equity withdrawal accelerated and drove consumption upwards, the Bank of England were willing conspirators. The consequence of this neglect was ten years of economic growth built upon rising household debt.

It was the commercial banks that betrayed this unsustainable formula that kept the UK economy growing. In the last six months the banks have begun to understand the magnitude of the debt problem in the UK. They have become increasingly reluctant to bankroll economic growth.

Understandably, the smarter banks have begun to tighten up on lending restrictions. They have also started to look at each other with more suspicious eyes. Everyone knows that UK banks are loaded with bad debts. As Northern Rock so vividly illustrated, widespread bank failure is a distinct possibility. That is why interbank interest rates have gone on a walkabout in recent months.

The Bank of England feels that an interest-rate cut will resolve all problems. Lower interest rates will encourage commercial banks to start lending to each other, and once that happens, the sector as a whole can start lending to households. Once the credit begins flowing again, house prices will begin to grow again, people will head back to the shops, and save the UK economy from recession.

What would happen if this this interest rate reduction manages to avoid a recession in the first quarter of next year? Let us suppose for a moment that house prices begin to grow again and people reengage with their credit cards and clean out the shops over Christmas. Personal indebtedness will rise, and with it, the prospect of even greater banking sector problems further down the road. The much-needed correction will be delayed, but not avoided. It will come, and the longer it takes to arrive, the more painful and protracted it will be.

Some people in the financial sector have already figured this out. The banks may try to jump off this train wreck. Credit availability may not improve despite the interest-rate cut. The economy may well slow despite the Bank of England's attempts to revive consumption. It may be tempted into cutting interest rates further. If it does, it will weaken sterling. Import prices will rise, and instead of higher consumption, the Bank of England will get raging inflation.

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