ARE British interest rates on their way down? Is it possible that 4.75 per cent will turn out to be the peak of the present monetary cycle and that the neutral level of interest rates will end being closer to 3 than to 5 per cent? A few months ago these would have seemed silly questions. In the 37 years from 1964 to 2001 British base rates had never spent a single day below 5 per cent. To suggest that interest rates would peak at a lower level than the trough of every previous cycle seemed like pure fantasy.
The almost unanimous opinion, as recently as April, was that interest rates were still abnormally low and that the Bank of England would have to continue its cautious tightening until they reached a “neutral” level somewhere above 5 per cent. The only question seemed to be whether the next rate rise would come before the general election or after.
Although I struck out against this consensus when I voted for a quarter-point rate cut in The Times Shadow MPC last December, this seemed no more than a tactical manoeuvre, related to the excessive relative strength of sterling. Once the foreign exchanges stabilised and the dollar moved onto a sustained uptrend, I quickly reverted to the conventional wisdom that the next move in rates would be up. Three weeks ago, I expressed a renewed personal preference for a rate cut – because economic activity was below trend, housing remained subdued and the global economy was weakening - but again this seemed a quixotic view, supported by only one other member, Martin Taylor.
What, then, has suddenly changed to convince most British economists that interest rates will soon start falling? What might be the economic impact of this turn in the interest rate cycle? And how far could the downtrend extend? The initial cut in interest rates, from 4.75 to 4.5 per cent, would hardly be noticed, but if expectations developed of a much bigger reduction, to 4 per cent or below, the effects on the economy would be profound. Asset and house prices would stabilise and then start rising. Consumer spending and business investment would recover strongly after a year or so, private employment would start growing and by 2007 the country would be back into a full-scale boom, relieving pressure on the public finances, but forcing the Bank of England to raise interest rates quite steeply in 2008 and beyond.
This is exactly what monetary policy exists for. Interest rates need to swing quite abruptly to act as a shock-absorber for the economy and stabilise the variables that really matter, such as employment, inflation and economic growth. In the eurozone, by contrast, monetary policy is used in the opposite manner — the European Central Bank takes pride in the avoidance of interest rate changes, but this “steady hand” policy destabilises the economy or condemns it to perpetual stagnation.
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Nobody would deny that the Bank of England is a more effective and dynamic institution than the ECB, but is it ready to respond to the present economic slowdown by shifting into expansionary mode? The answer is probably “Yes”. The minutes of the June MPC meeting, published last week, showed two members voting for a rate cut and most of the others saying they opposed an immediate easing only because it would surprise the markets. The MPC seemed to be using its June meeting to prepare the markets for an easing, which they will presumably deliver in July or, at the latest, August.
The justification for this change of stance can be seen in almost every recent economic figure around the world. Starting from home, every component of demand — consumption, investment, housebuilding and even government spending — has recently been weaker than expected, while employment growth has come to a standstill and inflationary pressures in the labour market have more or less disappeared. While these disappointing domestic figures have not (yet) remotely justified dire predictions of recession or fiscal crisis, they have suggested that the economy has decelerated to well below its maximum sustainable growth rate and could therefore do with some monetary stimulus. Moreover, the case for lower interest rates will become ever more persuasive in the next year or two (which is when a monetary easing today will become fully effective), when the present enormous growth of public spending begins to tail off.
But the clinching argument for immediate rate cuts — and for much bigger rate cuts than the market is expecting — is the state of the world economy. While the US economy continues to power ahead more or less as expected, the rest of the world is struggling. Oil producers are exacting a heavy tax from the world economy. Overcapacity in China is undermining industrial investment. Japan is suffering from the weakening of capital goods exports, even though the Japanese economy now enjoys decent domestic growth. And when we turn to continental Europe, the outlook changes from mildly disappointing to disastrous.
There is no need to describe in detail the economic and political troubles facing Europe. The grim story of Europe’s economic failure since the mid-1990s is familiar to everyone — even to the politicians and central bankers who are finally being held to account by the voters for their grotesque mismanagement of the single currency project. What matter from the British economic perspective are three consequences of the European crisis.
First, the EU will remain a very weak market for at least the next year or two. This will continue to restrain economic growth in Britain, since the EU will always be the country’s biggest export market.
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Second, eurozone interest rates are likely to be cut soon, at least to 1.5 per cent (as they were last week in Sweden) and possibly to 1 per cent or below. This will mean that rates of 4 per cent or above in Britain look even more anomalous than they do today. That in turn suggests the third and potentially the most disruptive economic consequence of the current EU crisis: the euro could fall very sharply. And with international investors still understandably wary of holding dollars, a loss of faith in the euro could send a flood of money into Britain, causing a damaging appreciation of the pound.
To protect Britain from these toxic by-products of the European economic meltdown, the MPC could be forced to cut interest rates by much more than the half-point now discounted in the markets. If eurozone rates were eased to below 1.5 per cent and the euro fell to around $1, Britain could easily see base rates returning to the 3.5 per cent lows they reached two years ago — or even to levels below 3 per cent, last seen when Churchill was Prime Minister and King George VII was on the throne.