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Rate Cuts Mask Darker Truths Behind A Sagging Econ

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Rate cuts mask darker truths behind a sagging economy


FOR all the predictability of the Bank of England's cut in interest rates to 4.5% last week, the news has left many in markets feeling decidedly unsettled. A rate reduction has seemed a surefire bet for the past two to three months. But this was no deeply rooted certainty. Remember that this was the first cut made by the MPC since July 2003, and it seemed unthinkable only a few months ago. The market was pricing in rate rises, and the MPC was warning about excessive personal borrowing.

So the move has resolved nothing and cured nothing. Yes, there is every sign that the economy has slowed, and a strong probability that it will continue to do so in the months ahead. So there was a case for cutting rates.

But there is every sign, too, that inflation is not going to abate any time soon. On the contrary: there is a strong probability that the targeted measure of inflation will continue to tease if not exceed the 2% target line.

This cut has thus no overpowering conviction to it. It has all the efficacious punch of a decision argued on the basis of the 'least worst option'. And it has opened up debate as to whether the Bank is now doing what it has no remit to do: targeting economic output rather than inflation.

Speculation as to where the trend of interest rates is "really" going is thus undiminished. It will now latch on to the Bank's Inflation Report, to be published this week, and to meetings of the MPC later this autumn.

Some saw in the short statement accompanying last Thursday's decision a signal that this was a one-off cut and the Bank was not intent on it being the opening reduction in a new easing cycle. It singled out the slowdown in household spending and business investment, but added that "looking further ahead... the rise in equity prices and the recent fall in the exchange rate should boost activity".

If this is what the Bank believes then it is unlikely to have cause to ease again soon. But how realistic is that? There have been three prongs to goad the MPC into action: the slowdown in the housing market, a marked fall in the pace of retail sales, and significant downward revisions to Gross Domestic Product at the start of last month. Arguably the last prong was the one that caused the most "ouch". The economy was judged to have grown below trend since the third quarter of last year.

It was this revision that caused a number of forecasters to trim their predictions for UK GDP this year. Investec, for example, revised down its forecast for growth this year to 1.9% and for next year to 2%. It now suspects that the Bank will be forced to revise down its forecasts of 2.6% for 2005 and 2.7% for 2006 made three months ago. In the words of DeAnne Julius, former MPC member and outspoken 'dove': "The British economy is near a tipping point, and a cut in interest rates is needed to prevent downward momentum from taking hold."

So how likely is that "boost to activity" on which the MPC has now pinned its hopes? The annualised rate of GDP growth in the second quarter was the slowest in 12 years. Retail sales continue to be weak and the manufacturing sector is in formal recession after declining for two successive quarters. Surveys show business confidence is continuing to fall. And the housing market continues to present an enigma that eludes those easy summaries of national average performance put out by the Halifax and the Nationwide. Scotland continues to enjoy rising prices for the most part. But in large swathes of the south-east there is evidence of a disappearance of buyers and prices having to be slashed in order to attract interest.

However true all this is, the figures that really preoccupy the MPC are in fact not to do with economic activity and output but inflation. The task of keeping the economy strong does not lie with the MPC, which has been charged by the Chancellor with ensuring price stability. This is monitored by the setting of an inflation target. It is the Chancellor's responsibility to ensure that, compatible with price stability, the conditions are in place to encourage growth.

So far the MPC has handled its responsibility well. The annual inflation rate has been kept within 1% and its target of 2% for no less than 87 of the 100 months since Gordon Brown granted the Bank of England independence in 1997. In only one month during that stretch has the rate exceeded 2% - and that was seven years ago.

But inflationary pressures have recently been rising. The headline Retail Price Index measure is at 2.9%. The targeted measure of Consumer Price Inflation is exactly on target at 2%, having risen from 1.1% last September. Driving this climb have been the sharp rise in the price of oil and the fall of the pound against the dollar. So the Bank now has to ponder the impact that the continuing strength of oil prices will have on inflation, together with rising signs of trade union activity in the pursuit of public sector wage claims.

Cutting rates adds to the Bank's problems in two respects. First, it has the effect of encouraging borrowing over saving and increasing consumer demand for goods and services, thus putting pressure on prices. Second, any short-term fillip to activity and growth that may result from a cut may work to obscure the forces that are bearing down on the economy.

Two are of particular concern. One is the cumulative effect of Gordon Brown's budgets in raising the tax burden both on the personal sector and on companies. The second is the baleful effect of regulation. A short-term stimulus may thus enable the Chancellor to claim that the economy continues to do well given the oil price shock it has had to absorb and that he has no need to alter fiscal policy from its alleged "prudent" course.

But we well know that government borrowing continues to run higher than forecast in the Budget and that the Chancellor has recently altered the definition of the cycle to avoid a breach of the Golden Rule, thus giving him more legroom. On a strictly economic view, there is an argument that Brown is right to take action that would avoid having to curb expenditure or raise taxes at this point in the cycle. But we know tax rises are still looking probable next year.

The alternative, of course, is to curb government spending and cut taxes. As the example of the George W Bush administration shows, you can cut taxes and, thanks to the resulting growth in the economy, increase government revenue. But this, in the grim Brown universe of public sector command-and-control, is "not an option".

Britain's economy is sagging, not in spite of the Brown chancellorship but because of it, and this is likely to become even more starkly clear if the recent fillip to global activity continues to gain strength. But few are banking on it.

That is why, despite last Thursday's upbeat reference to a coming "boost in activity", speculation about further rate cuts has not at all dispelled. For the record, Merrill Lynch is forecasting a cut in interest rates to 4.25% in November and Investec has pencilled in a further cut in the first half of next year to take rates down to 4%.

These projections hardly suggest that the economy is about to take a turn for the better. They also assume that inflation does not rise further. But few are so sure.

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I was quite liking it until this point....

The alternative, of course, is to curb government spending and cut taxes. As the example of the George W Bush administration shows, you can cut taxes and, thanks to the resulting growth in the economy, increase government revenue. But this, in the grim Brown universe of public sector command-and-control, is "not an option".

Um... Bush's tax cuts haven't increased revenues. They've let government revenues by 4.6% of GDP (from 20.9% in 2000 to 16.3% in 2004), and are now regarded by most economists as a fiscal disaster.

Lower taxes = higher revenues is a now largely discredited belief based on the "laffer curve", which inspired Reagan's "voodoo economics" in the 1980s. It can work, under certain circumstances, and in high-tax economies, but generally it's just a way to justify a conservative social agenda.

See http://www.rgemonitor.com/blog/roubini/91202/ for a good discussion of this.

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