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The last cut is the deepest

There was an element of surprise when the Monetary Policy Committee (MPC) cut base rates in July, not least because it marked Mervyn King’s debut as chairman. He is generally regarded as a hawk on inflation and interest rates. While it’s true that as a member of the Committee since 1997 he voted in favour of all but two of the previous 15 rate cuts, he also voted 22 times for an increase and was with the majority on only nine of those occasions. So to loosen policy on his first appearance as governor was something of a break with past form.

This ninth reduction since February 2001 has taken rates down to 3.5%, the lowest level since 1955. The last time they were this low, the Conservatives won a general election and Chelsea were League champions – a coincidence of events none of us will live to see again!

The downward move was also surprising because it was hard to see what had changed in the previous few weeks to justify a rate cut. The economy was still growing at a below-trend rate and still relying heavily on spending by indebted consumers and government to make up for weak investment spending and exports.

When the minutes of the meeting were published, the MPC cited four reasons for the cut. The first was that house prices were unlikely to accelerate, the second that there was less risk than earlier in the year of stimulating further consumer borrowing, the third was that the imbalances between various parts of the economy would not widen and, finally, that sterling had strengthened. Unfortunately for the policymakers, statistics published since the meeting contradict the first three of these arguments and raise doubts about the MPC’s decision.

According to the Nationwide and Halifax, house prices rose by between 0.6% and 1% in July. Although this is not an acceleration in prices, there is clearly still a lot of life left in the housing market. Second, retail sales bounced back strongly in June, rising by 1.9% on the month and 6% over the past year. This was the biggest monthly increase in high street sales since January 2000. On top of this, the Bank of England published figures showing that consumer net borrowing in June rose to its highest level since records began in 1993. At £10bn, it rose by £1bn in just one month. None of this implies that households needed the incentive of a rate cut to keep borrowing and spending on track.

The picture that emerges from this is of an economy which is unbalanced and could now become more so. Since GDP grew by just 0.3% in Q2, the apparent strength of the consumer suggests continuing weakness elsewhere, particularly in the traded goods sector. Although in the first quarter of this year the UK did record the first balance of payments surplus for over four years, this was largely accounted for by a record surplus on earnings from overseas investments. The goods deficit in May was still a massive £4.2bn, as exports continued to weaken in the face of weak overseas markets.

The conundrum for policymakers is that the two most buoyant parts of the economy – the personal sector and government – are both dependent on borrowing to sustain spending. Borrowing today may help underpin spending and keep the economy moving forward in the short term. It will also constrain future growth, and by more so in the current low inflation environment.

Debt now is a burden for longer than it was in the past, when inflation was in double figures.

There will come a point when households’ willingness to take on new debt reaches its limit and, with borrowing now approaching 120% of income, that time is not far off. Equally, recent figures showing a surge in government borrowing suggest the Chancellor may have to choose between raising taxes and curbing spending rather sooner than he was expecting. In these circumstances, what options will the MPC have to justify the widespread expectation that the economy will recover next year and return to trend growth?

More reliance will be placed on the exporting sector, not only to rebalance the economy but also to keep activity on track. Although the case for further cuts in interest rates seems to have been weakened by the latest consumer spending and borrowing numbers, cuts to 3% or less next year cannot be ruled out. If exports hold the key, the exchange rate moves to centre stage and, with the consumer retrenching, lower base rates could keep the economy growing. This was the MPC’s fourth reason for the reduction and perhaps the most convincing one.

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