|
Dear Mr King
We have not offered the MPC the benefit of our advice for the last quarter because we discerned correctly that the Bank would not make any change to interest rates in the election period or immediately after. To argue for the necessary reductions would, therefore, have been a waste of our time.
Those inhibitions are now gone, the economy has deteriorated further, the deflationists` chorus ritually calling for higher rates has stilled, the need for a rate reduction has grown, and we sense that now you will give interest rates one of those minimal nudges down by one quarter percent the MPC is so fond of. Therefore we are writing to say that this will not be enough. The reduction needs to be more substantial because the deterioration is setting in fast.
The two basic reasons for a rate reduction are to boost a flagging economy and to help an overvalued pound to find appropriate, natural, and competitive, place in the currency adjustments currently going on.
The economy is slowing. Growth is below trend and trend is, in any case, too low to be healthy. Consumer demand is down, house prices have slowed and may even be falling, credit isn`t expanding. So all the drives to the growth of the last few years have weakened while the other booster, public spending, will not grow at its previous rate. The prospects are, therefore, that unemployment will stop falling. It may even rise, given the fact that many new jobs have been generated in the consumer sector which is now slowing. Any fall in employment will reverse the benign cycle of more people in work paying more taxes and reducing social security expenditure.
Once started, such a wind down will be difficult to stop and will certainly require more drastic measures. Better, therefore, to boost demand at this stage when the trend is clear but not yet irresistible. The only way to boost demand is by lower interest rates and, hopefully, a more competitive exchange rate. With government spending at a plateau, and higher government borrowing (unnecessarily) ruled out by the golden rule the Bank is now the only effective regulator of demand. It must act to boost it.
It is also the only instrument able to make sterling more competitive by bringing interest rates down. The pound is substantially overvalued as is clearly indicated by the large balance of payments deficit. It is, nevertheless, being propped up unnecessarily by interest rates which are too high for purposes, presumably as a check on inflation. This makes imports cheap and forces companies to cut costs, which in turn makes our exports uncompetitive, overpriced and less successful.
Which puts the UK in a very difficult situation in the process of currency adjustment now going on. The dollar needs to come down and over a period it will because a devaluation is the only way to deal with the gaping trade deficit. Logically, if money flows out of the dollar it will go into the euro which should rise and would have done so had not the constitutional crisis, the general loss of confidence produced by Europe`s disagreements and loss of faith in its future, and the effective collapse of the Stability and Growth Pact. Indeed these follies would appear to be the only means of achieving a devaluation available to the EU.
In the process sterling must, if we are to regain competitiveness, fall with the dollar, not rise with the euro. It can only attain a natural level at which markets can work properly if our interest rates are at a level very similar to theirs. In fact they are double and have been so for a long period. It is important that the MPC devote serious thought and analysis to this issue. It should explain why the difference is so substantial but it has avoided the issue so far.
Our Recommendation, suitably moderate so as not to alarm the MPC, is for an immediate1% reduction in rates as a preface to a later 1% fall. It will be objected that this could reactivate the house price spiral but of course the Bank is not the regulator of house prices, nor should they be central to its considerations. That problem is the government’s which needs to correct its own failures to increase the supply of housing and to boost new build.
The Bank`s governing rubric: inflation at 2%,allows a substantial reduction in interest rates now. Inflation has risen but is not yet over target. There is no way projecting the rate two years forward as the Bank usually does to justify higher rates, if present deflationary trends are allowed to go up to justify a rate over target. Quite the contrary. Add in the other factors to which the Bank needs to pay attention, such as growth, employment and the general health of the economy and the case for a substantial reduction is clear. Delay can only allow a further degeneration in the situation. This will feed on itself and undermine confidence thus strengthening caution and job shedding, which will compound the problem. It is important to act now, not to try to catch up later. |
