Splitting the difference

Today's decision was unusual in that it could have gone three ways - it could have conceivably been a half point cut or no cut at all.
The reason there's such a wide span of options is that the economy is sitting at a crossroads. It could take one of three routes from here, but we don't know which one it will be. Unfortunately, we know those three routes take us to three very different destinations with very different implications for interest rates.

One route is towards an unpleasant recession -- the kind of early 90s experience.. or even worse, the Japanese 1990s experience.

With the housing market falling and the banks suffering, you might reasonably worry about such a scenario. And if you do, you would probably think a half point cut is needed. i.e. the sort of central bank action that you get in the US.

But while the US appears to be on course for some kind of recession, the situation is far from clear-cut in the UK. We still face a second possible road that takes us towards inflation.

With the pound falling and global commodity prices rising, we might actually need some kind of significant slowdown just to kill off the pressure for prices to rise. If we knew we were heading in that direction, it would have certainly justified holding rates as they were.

In the event, the Bank opted to split the difference on rates, evidently hoping the economy will take the third road -- towards a rebalancing of the economy.

This involves a relatively gentle slowdown with only a temporary upturn in inflation. The rebalancing part of the story sees the economy shift away from its dependence on consumer spending towards exports.

We can be sure that this third road is the one we want the economy to take. Unfortunately, we can't be sure it's the one the economy will take. Economists are divided over which direction we are moving in.

The Bank of England's statement -- released with the quarter point cut -- makes pretty clear that they recognise the economy is sitting at a crossroads, and all three routes are still possible.

Their job is simple: to navigate us towards the good rebalancing route, away from the bad inflation and ugly recession.

Comments   Post your comment

  • 1.
  • At 04:57 PM on 07 Feb 2008,
  • Peter Hawkes wrote:

There are two reasons why I find your pessimistic appraoch difficult. First, the inflationary pressures are largely not that at all. The price of energy is rising not because of increasing UK demand but because of world prices. Higher energy prices with relatively little option to reduce energy use (home and transport) takes money out of people's pockests and leaves them less to spend in the high street. How is this inflationary? Second, your view of the housing market is, I think, too economist based. Housing is unusual in that demand is very inealstic. Households do not disappear or immigration or emigration rates alter rapidly. So the normal rules of supply and demand do not apply too well. I really think you need to work these issues through more clearly before pronouncing on the future economy

  • 2.
  • At 05:23 PM on 07 Feb 2008,
  • robert cargill wrote:

I agree with you Evan; thankfully the BoE have moved away from ''our remit is to control inflation'' - to a much more balanced and more important responsibility of economic well-being.

Whilst there are always thousands that CLAIM a good recession will sort out all the 'greedy speculators' - they cannot be serious as they too will feel the effect of that.

The BoE have not publically put the UK economy before ''inflation risks'' - but it clearly is more important - glad to see they have recognised it.

Slow down is inevitable - the UK could not sustain 3%+ in any case and the rebalancing will not be a bad thing.

Well done!

  • 3.
  • At 05:35 PM on 07 Feb 2008,
  • john thomas wrote:

Mr Hawkes, inflation is a measure of price movement. If the cost of fuel risines it contributes a percentage increase to the measure inconjuction with those other commodities in the basket.

Houses are different in that rarely are people forced to move. In the last ten years property has increasingly ceased to be just a home but, for many an investment, a pension fund. 2.5 million people pay rent to .5million buy2let landlords. The housing market has become a bubble, just like in the late '80s. It is bursting...thank goodness.

  • 4.
  • At 05:42 PM on 07 Feb 2008,
  • Robert Woodfield wrote:

I see the MPC's decision alomg similar lines to Evan. That is as they are not quite sure where we are better to save a further 1/4% for next month or even April. Why? Because Banks can rein things in a tad by not passing on the full reduction in new mortgage deals/ and holders of loans/overdrafts (witness also Egg's behaviour to some of its allegedly more 'profligate' customers). However a full 1/2% off rates wouldeffectively leave no/very little room for another 'nudge on the tiller' for several months.
When a fell walker is in thick mist s/he slows down while more exact bearings are discovered. Thus mERVYN KING & today's MPC decision IMHO!

  • 5.
  • At 06:11 PM on 07 Feb 2008,
  • Ian wrote:

Listening to Bloomsberg analysts today they clearly believed the UK housing market had strong similarities to the US but months behind the US. Both Alan Greenspan and Warren Buffet have in speeches made over the last few months indicating a similar conclusion.

What Britain requires is the same as the USA - EXPORTS (i.e. income) to fund its expensive spending aspirations. Either that, or changes need to be made to decrease our spending patterns.

If no change happens - then the result will inevitably be a harder landing later.

Based upon historically analyses, there is no shortage of accommodation in the Uk,and prices relative to earnings are at a peak, borrowing (government, personal and institutional - such as hospitals0 is at an all time high relative to national incomes, pension funds are depleted and the young are with student loans.

As someone who has benefitted hugely from inceased house prices during my life, I look at youngsters coming out of university - and their outlook and financial position - and this is truly worrying.

On one hand they have little opportunity to participate in even moderate living standards without huge loans, and on the other - in the future paying for the national and civil service pensions will place them under an additional burden in the future.

There is a feeling of unease in the UK - the balance is wrong.

The BOE has 'pushed on a piece of string' in reducing interest rates - but the outlook for substantial house price reductions does indeed look similar to that in the USA - and maybe we should wlecome that as a key part to motivate our youngsters - with a work rather than the speculative ethic which appears to have caused much of this crisis and is evidenced in the current BTL problems.

I believe some good will come out of the changes that are about to occur - just like pruning a bush encourages fresh growth.

  • 6.
  • At 06:18 PM on 07 Feb 2008,
  • Damian wrote:

The MPC's prime remit in setting Bank Rates is to limit movement of the CPI to 2%pa with 1% margin. House prices are not covered by the CPI and should be of no interest to the MPC save as they may affect its constituents and indirectly liquidity in the London Money Market.

Availability and cost of capital for business and investment is within the Treasury's remit as it controls money supply through its management of the Treasury Bond market- or should.

There is no reason for the Bank/MPC to reduce interest rates as most indicators point to higher costs with staple or basic foods and energy having experienced double digit price increases in the last six months. Indeed it should be raising them and sterling to ameliorate these price rises on the Brown Formula so today's action was incorrect.

It is the Treasury that should be buying in Treasury Bonds to provide liquidity and expanding the money supply which it should have controlled by their sale.

It would be far better for the Government and the financial system that has created problems to face their ramifications and businesses to cut costs rather than wealth being subsidised by investors.

In the face of obvious demand for money the State is causing lenders to subsidise borrowers and primarily because of cumulative failure by the Government to manage the economy optimally and through a completely flawed system.

The MPC has cut rates 50bp or 9% so far, now we need to see cuts in Government and business costs to match- Brown and the Cabinet should cut their salaries in line.

  • 7.
  • At 06:19 PM on 07 Feb 2008,
  • Mel Kenny wrote:

Mr Thomas, if we consider inflation to be always and everywhere a monetary phenomenon, then people will spend less on other things and therefore increases in the cost of fuel for example, would not be inflationary...

  • 8.
  • At 06:28 PM on 07 Feb 2008,
  • Ed wrote:

Peter: rising energy costs are inflationary because a) everything contains some element of energy in its pricing: whether it be the electricity used to power a factory or a shop or the diesel used to deliver the goods to the warehouse or point of sale, and b) on the demand side, increasing energy or fuel prices feed into demands for higher wage increases, particularly because they are highly "visible" prices. Flat screen TVs may be falling in price but the average person is not buying one every week: whereas they are filling their petrol tank up every week or paying their gas bill once a quarter.

In fact I wonder whether it's inflationary pressures elsewhere in the world that might influence us more: inflation in China is rising , leading to the imposition of price controls (but price controls often do not work, or lead to shortages instead) - if that were combined with a slowdown in the Chinese economy (relatively speaking) caused by a Western consumer slowdown, it could turn nasty for the Chinese stock market, and, given how much the Chinese middle classes have invested there, that could spell trouble for the Chinese government.

Of course, it might not. It is possible that the credit crunch won't have too much effect on Western credit card borrowings, and it is possible that consumers will continue to spend at a reasonable pace. It is possible that Chinese inflation will come back under control. It is even possible that pigs will fly and that everyone will live happily ever after.

Someone told me a joke once: "An economist is someone who can tell you tomorrow why the prediction they made yesterday turned out to be wrong today".

  • 9.
  • At 06:32 PM on 07 Feb 2008,
  • Leigh wrote:

How are we going to shift to the economy away from consumer spending to exports when all our manufacturing industry has been decimated?

  • 10.
  • At 06:33 PM on 07 Feb 2008,
  • glenn sayward wrote:

Interesting on the fence observations.

For those of us that live in the real world inflation is here and it is above 10%! Food, utilities, road fuel, etc etc have all risen above 15% in the last year - the spin needs to be unfolded about the government statistic of 2% - inflation is not an effect of these interest rate cuts as it's already here. Coupled with the unravelling of many fixed rate mortgages many people are really struggling and hence spending on non-essentials is tight and I ought to know owning a shop that relies on just such expenditure. Most people believe that there is a recession on the way because they are being told so 24 hours a day by the new channels.

The house market can't possibly go down too much as the population is increasing greater than the number of new houses.

  • 11.
  • At 06:59 PM on 07 Feb 2008,
  • loyaultiemelie wrote:

I'm with John Thomas on this one. Inflation is inflation is inflation whatever the origin and that's what we'll get more of if we keep lowering interest rates. Ultimately it's a political issue - are we going to continue to feed the consumption-oriented elements of our society with their insatiable hunger for credit which is basically why we are in the situation we have reached(and is the short-term voter-friendly but ultimately inflationary solution): or are we going to maintain economic stability by accepting that low inflation has to be the primary economic target of any responsible government?

  • 12.
  • At 07:07 PM on 07 Feb 2008,
  • Bob Burwood wrote:

Each time we go through the process of higher intrest rates, inflation always follows. If an employees basic
living cost keep rising and their intertainment budget drops, they are forced to approach the employer for an increase. To cover the immediate higher costs and the potential future increases they have to ask for increases much greater than present inflation. To pay this the employer has their own range of increased costs so they are forced to increase their prices to cover the immediate costs and allow for the potential increases during the coming year. This government has played a major part in causing the greater part of the increased costs.

It takes longer each year to pay the taxes, reducing the disposable income.
The massive increase in state employees and their costs means that we may now have passed a point of no return, and they will need more and more tax to keep this ball rolling. So the employees will have to keep asking for more and more money, inflation

  • 13.
  • At 07:09 PM on 07 Feb 2008,
  • david webb wrote:

Peter Hawkes, would you please remember that we pay for imported commodities in pounds sterling which drops in value when interest rates fall (as it has today). We get less oil etc. per pound, which is more inflation.

Price rises are already very noticable on the high street-food,energy and of course the increases in the labour tax burden,(albeit stealthily imposed).They are all types of increased costs squeezing purses tighter and tighter.This at a time when most big companies are already scaling back,( overtime and all business expenses ).Many UK office based jobs are being outsourced to India,further undermining peoples' feel good factor for the future.More so amongst those who have experienced past recessions .All bad enough without the debt burden of the last decade.I think it will be a good 6 months before the UK knows where it is heading.And things really turn down once the collapsing bubble market in housing feeds through to employment-construction layoffs,building materials,architects etc.But,in my view main land europe will suffer just as much.Followed by worse in Eastern Europe.But not over night.

  • 15.
  • At 07:26 PM on 07 Feb 2008,
  • George wrote:

There is another option you do not mention, and that is for Gordon Brown to reduce our taxes that will leave more money in our pockets to stimulate the economy. Unchanged interest rates can then prevent devaluation of sterling, be used to supress inflation, and not reduce the savings of pensioners. Of course he will have to reduce the wasteful public spending ('investment') which has not produced improved services, but that is something the socialist thinking BBC does not consider.

  • 16.
  • At 07:52 PM on 07 Feb 2008,
  • Colston Hicks wrote:

The last thing we want is a cut in interest rates, in the US and the UK. Cheap interest rates advised to Gordon Brown in 1997 caused zero savings culture and horrific house price inflation in both countries.House values in early 2007 were about 2 1/2 times what they would have been with normal inflation.The increased value put the mortgage cost above anyone's capability. Nobody can afford to buy.To correct the turmoil property values have to drop about 40%.( The Aviva property has already dropped by 35%, according to one paper. The only effect a cut in mortgage rates can have is start the 12% to 14% annual inflation off again. God forbid that anyone could be so foolish.The only solution is to restart the pre 1997 savings culture.Bring back the building societies where the saver gets a fair interest rate ( not the 1% and 2% they were able to pay when they became banks.

  • 17.
  • At 08:17 PM on 07 Feb 2008,
  • Richard Marriott wrote:

Mr Hawkes, inflationary pressures in the economy are certainly a lot higher than the 2.1% CPI figure would suggest. Plus, it is the staples of life which are increasing most - energy and food - the poorer you are, the more you feel it. No wonder people laugh when told inflation is running at 2.1% - it feels much, much worse than that.

  • 18.
  • At 08:23 PM on 07 Feb 2008,
  • Martin Gatehouse wrote:

I agree with Mr Hawkes. The BoE is fooling us into believing that their tinkering with interest rates rises materially affects inflation in the UK. The main drivers of inflation is 2008 will be energy prices, raw material prices (steel, etc), asian exports and food prices, all of which are set to rise regardless of UK demand and interest rates. "It's gone up 10% - take it or leave it" is the clear message to uk business and consumers of these world commodities. Buying half as much? its still 10% more...sorry...the oximoron of rising prices and recession is upon us!

  • 19.
  • At 08:27 PM on 07 Feb 2008,
  • Brian Marshall wrote:

With housing in trouble, and the spectre of large-scale negative equity returning, some pressure had to be taken off people with high debt burden. At the same time with Euro zone inflation at record levels the Bank of England can't afford to cut interest rates agressively. The middle course of the small cut looks right for now.

  • 20.
  • At 08:34 PM on 07 Feb 2008,
  • Scamp wrote:

Big mistake.

A BoE that genuinely cared about the economy rather than the financial services sector would have put interest rates up by a quarter or half point to kill off the credit binge and house price inflation once and for all.

As Martin Wolf said in the FT ""A financial sector that generates vast rewards for insiders and repeated crises for hundreds of millions of innocent bystanders is, I would argue, politically unacceptable in the long run."

Give these morons and inch in the form of a quarter point rate cut and they'll take a mile.

  • 21.
  • At 08:47 PM on 07 Feb 2008,
  • Andrew wrote:

I think the slow approach to reducing interest rates is wise. Assuming many home owners (65% UK pop) are feeling the pinch right now after years of credit-fuelled overspending, thrusting more cash in their pockets with a big chunky (US style) rate cut would likely just fuel yet more spending and increase inflationary pressures. Drip-feeding the interest rate cuts will slowly relieve pressure on over-stretched households without creating an instant false sense of 'wealth' and hopefully dissipate the possible inflationary effect of those cuts.

  • 22.
  • At 08:58 PM on 07 Feb 2008,
  • Observer wrote:

The Australian Central bank has raised interest rates to contain inflation. Similarly , the ECB has decided to keep the interest rate on hold and central banks of many other countries have either raised rates or kept on hold. I do not think the BOE's decision to cut rates was a wise decision. Prices are rising fast in the UK, and the rate cut will certainly fuel inflation. Lets bear in mind that the US slowdown is a US problem, and its impact on the world economy is minimal.

  • 23.
  • At 09:05 PM on 07 Feb 2008,
  • Chris Clark wrote:

Thank you Evan for an excellent overview. It is interesting to me that the BOE only has one lever, Interest Rates and its only objective I believe is to keep inflation in a range.

Now it seems to me the chances of it going below the range are pretty slim, even longer term, yet it risks it going too high because of fears of a slowdown..where is that in its brief?

On the number of levers overall we seem to be in a bit of mess as monetary policy and fiscal policy are done by two different bodies. Ideally we could do with an injection of public funds but previous over-optimism means we are fully mortgaged. I can see how confidence is gained by an independent view on monetary policy - its the BOE not left to the vaguaries of pliticians, so why not do the same with fiscal policy...this year Mr. Darling you can only spend this much? That would be radical!

  • 24.
  • At 09:25 PM on 07 Feb 2008,
  • stanilic wrote:

Evan, may I compliment you on a very balanced and agreeable way of presenting the arguments.

I have been through too many recessions and am very fearful as to the current prognosis. A gentle slowdown that kills off inflation would be ideal and one can understand the BofE seeking that solution.

Unfortunately the combined inflationary effect of rising fuel costs, commodity prices, labour costs in China and domestic taxation are already affecting the UK economy. There is evidence that consumer demand has already shrunk, albeit slightly. Add in the growing restraint in the issue of credit as banks refocus their portfolios to maximise profits and we have changes in the supply side of the economy as well.

In the not too distant future companies who are not generating cash will begin to cut back on their labour forces. Unemployment will return and that is when all bets for a soft landing are off.

I know that I am not being as measured and as balanced as you, but then I am sitting out here in the middle of it all having been here before.

  • 25.
  • At 09:52 PM on 07 Feb 2008,
  • Paul Smith wrote:

Mr. Hawkes has no concept of a very good point that evan brought up on TV the other day, The big elephant in the living room Peak Oil.

It is both inflationary and could cause a depression, but that kind of thinking is way out the loop for Mr. Hawkes.

Seems like he lives in a world where expontential growth can continue forever, May i suggest the revised edition of limits to growth for him.

Mr. Hawkes, i am afraid to tell you, but the party is well and truly over!

Still, it will be fun telling your kids you lived through the best ten years man has ever experienced!

  • 26.
  • At 10:02 PM on 07 Feb 2008,
  • John North wrote:

Doubt the power of real inflation (much higher than the government's preferred measure of less than 3%)to de-rail the economy at your peril. For those families who are now facing an unprecedented surge in overall living costs the only route to survival is to trim expenses wherever and whenever they can.This goes way beyond the paliative effects of marginal interest rate changes and will only show through in the economy over a six to eighteen month period - by which time the course will be set and the damage done.Pity those who cannot keep their heads above water.The human costs will be immense.

  • 27.
  • At 10:14 PM on 07 Feb 2008,
  • Chris wrote:

It is incorrect to say inflation is a measure of price movement. Inflation is the decline in value of your money due to oversupply. Take into consideration that all money is created as debt and salary increases never keep up with inflation you have a recipe for creating serfdom. It's that simple. Study the BoE, Fed reserve monetary systems.

I think the most pertinent question to ask our humble servants in government is why give the BoE(privately controlled) the job of creating our money and allowing them to charge interest when the government can create the money themselves and NOT charge themselves interest which we pay for in taxes?

  • 28.
  • At 01:27 AM on 08 Feb 2008,
  • Angel wrote:

Pitter H.
I would try to be optimistic as much as I can, however, we can not expect the overall-trend to keep-up all the time/forever., etc., (i.e. if this will be the case, one must recall all Economies books from every single Uni’s shelves in the U.K and rewrite them again from the scratch..)

  • 29.
  • At 11:11 AM on 08 Feb 2008,
  • Bebedi wrote:

In the arguments over inflation everybody forgets the real inflation is RPI and not CPI. CPI works in the US because the majority of their mortgages are fixed over the long term 10-20 years. Here however we have the scenario where approx 2 mil people are coming off fixed term mortgages taken when interest rates were at historic lows of around 4%. For these people the inflation is close to 8-10%. The RPI btw is hovering around 4%. There are some with just 5% equity left on their homes because originally they took 80-90% mortgages and then used their house as collateral to take on more loans. These people are looking at new rates of close to 8-9%. Risk prices have just shot up and most of them will be struggling in another 6 months.
Another very important point is food prices. If you picked up a pan of slice bread recently it should give you a good measure of where prices are heading. Fuel prices aren't helping. Research has shown to produce one cal of food it takes approx between 12-16 cal of fuel. This inflation is very dangerous because suppliers cannot absorb this input prices and likewise retailers have no more slack but to pass these on to consumers. There are tough times ahead and although some people are complaining about too many people being too pessimistic, I think on the contrary, when the storm clouds were gathering too many people were too optimistic.

The dilemma in the UK is that we have falling growth and yet we have increasing inflation. When I was young this was caused Stagflation and was a very bad scenario ; why is nobody mentioning stagflation now.

Unfortunately ths current situation will not be solved by 1/4 or even 1/2 % reduction in interest rates; it needs a complete restructure of the economy and as such house prices need to fall significantly.

It will hurt !!

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