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Economics – The first cut is the simplest

It all seemed so predictable and justified. Predictable because the voting at
the Bank of England’s Monetary Policy Committee (MPC) had moved steadily in
favour of a cut, from 8-1 (in favour of no change) in April to 5-4 in July.

So when the committee met in August, it would have been more of a surprise if
rates had not come down. The fall from 4.75% to 4.5% was the first change in
base rate for 12 months and the first cut since July 2003. Now the rate cycle
has turned, more cuts are expected and the HSBC forecast is for rates to drop
below 4% in 2006.

Justified because of the mounting evidence of weakening economic activity. As
inflation risks diminish, so the MPC’s attention turns to growth, and the pace
seems to be slackening across the board. Permanent sales on the high street
testify to the fragile state of consumer spending while the CBI constantly
reminds us of the dire state of manufacturing. And the housing market seems at
last to have responded to the tightening of policy that began in 2003, with both
prices and new lending continuing to ease. So when the growth of the economy in
the second quarter came in at a below-trend 0.4% (compared with the previous
three months), it was in line with what the other statistics were saying. The
year-onyear growth rate has declined to 1.7%, the lowest in 12 years. This
compares with the trend rate of around 2.5% and the Chancellor’s budget forecast
of 3.0%-3.5%. For once, Gordon Brown looks well wide of the mark.

When the parlous condition of public sector finances, the ongoing weakness in
the key export market of Europe, five consecutive monthly rises in unemployment
numbers, and the growing evidence of debt pressures on a fragile consumer are
factored in, it is clear that the flagging economy is in need of a boost. With
the Chancellor forced to redefine his “golden rule” to make it appear as though
he is being prudent with public sector finances, it is clear that monetary
policy rather than fiscal policy must provide the stimulus for faster growth.

By cutting rates, the MPC hopes to do three things. The most obvious is to
make it clear that the period of rising rates is over – for now, anyway. Second,
to make it cheaper for those with little debt (particularly companies) to
borrow. And third, to reduce debt servicing costs for borrowers, thereby freeing
up some spending power and accelerating the rate of debt reduction.

It is doubtful whether a 0.25% rate cut will achieve very much. It will
certainly signal that borrowing costs have stopped rising but it may take
further reductions to ease debt burdens significantly, and most observers expect
further cuts in the coming months. And the boost to consumer confidence may be
offset by the rise in unemployment. In any event, given the time it takes for
the full effects of rate changes to work their way through, this will be a poor
year for growth whatever else the MPC does between now and Christmas. And the
rate cut may not be such a good idea in the medium and longer term.

When rates began to move up in November 2003, it was clear by then that
above-trend growth was being fuelled by an increasingly indebted personal
sector, an overheating housing market and government borrowing.

Investment spending, on the other hand, was pretty flat and international
trade was making a negative contribution to growth. The economy was, therefore,
becoming very unbalanced and rising interest rates were prescribed to cool

It seems to be working, although it took 18 months or so and another four
rate rises for the medicine to take effect. But, while output growth has slowed
and domestic demand eased as intended, investment and export growth are still
disappointing. Cutting rates now may well help total demand to recover but the
same imbalances that led to the policy tightening nearly two years ago could
return – and soon. Rates at 4.75% were not the major constraint on investment
(companies are relatively cash-rich) or exports, so cutting to 4.5% is unlikely
to lead to more capital expenditure or a surge in overseas sales.

Despite being predictable and justified, the policy easing might simply lead
us once again down the same path of too much consumption and borrowing. GDP
might well pick up, probably after a few more tweaks on rates, but rate cutting
is not the answer on its own. Although supposedly the first step in reviving
activity, this cut in rates leaves important issues about contributions to the
UK’s economic growth unresolved.

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