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In advance of the next decision on interest rates.
Dear Mervyn
We have not written to you before the last three MPC meetings because we considered that given its record the MPS would ignore the fact that British interest rates have long been too high compared to both Europe and the US and settle for a holding course. We were right.
However, we are now in a more uncertain situation that we have encountered before. The inflation prospect is unclear however much hyped in your speech last month. The stock market is dithering on the brink of a fall; something far stronger than “sell in May and go away”. Currency markets are unpredictable with the dollar beginning a long overdue fall, sterling fluctuating and the euro going up. Even the measures you regularly cite are not clear. House prices have rallied then stalled. Consumer demand is faltering but not in all sections and the debt burden, while clearly excessive, has not yet choked off everything nor led to the earlier consequences of negative equity and repossessions. In this situation the pundits give conflicting advice inevitably conditioned by their own interests, with the CBI and industry urging a reduction of interest rates, the financial sector urging an increase and the bemused urging you to stand at an interest rate which is far too high for the needs of the productive economy though not of course the financial interest which the City represents.
Our conclusion is that we and the world are balanced on a knife edge. Our fear is that the Bank, inhibited by the lack of clear signals, will opt to hold existing rates. This would be wrong and to raise them even worse. Despite the confusion the overall pattern is still clear. The pound, like the dollar, needs to fall and markets will ensure that both do. It would be counterproductive to attempt to resist this. The euro will go up and the European Bank, still the most monetarist of our central bankers, will delight in this and keep interest rates rising despite the departure of Herr Issing. The dollar will fall and neither the FED nor the new treasury secretary will resist this opening up the possibility of a fall of 40% of the type which had such benign results in the eighties.
In that situation you have a responsibility to pursue BRITISH interests. Those point to a substantial (and necessary) fall in sterling. The Bank should signal its readiness to go along with this by a reduction of interest rates now. You will want this to be grudging, we would urge that it should be substantial at 2%. In support of this we would emphasise:
- Bankers, the financial community and the MPC are obsessed with inflation. They always exaggerate it, as you did in your speech last month, and predict dire consequences which haven’t, so far in the history of the committee, materialised. It’s easy to say that unless action is taken now inflation will rise over two percent in two years’ time. That conclusion is always enunciated with authority and a knowing look of wisdom which is absolutely unprovable. It’s a matter of faith, not science. The MPC as always ignored underruns of inflation of the type which, if its 2% target was the real concern, should lead to a reduction of interest rates. The Bank never wants to make this, though it should, while it has always been terrified by the mere possibility of an overrun which never in fact happens.
In the present instance the basic cause of inflation fears is oil and fuel prices. There is nothing the Bank can do about this external pressure short of using higher interest rates to depress the economy that it is damaged which is masochism not management.
The consequences can only be damaging. So the Bank should stop trying to inspire fear and give up meaningless threats.
So we reiterate our often given advice. Inflation is no longer a threat with so much surplus production power coming on stream in South East Asia, with globalisation and IT bringing production and transaction costs down, the power of labour is broken (where is wage pressure?) and producers have lost control of costs. So what now could possibly justify an increase in interest rates adding further to costs and inflation with all the consequences that would have.
- The Bank should have other concerns as well as inflation. For the present it can ignore this non threat, stop banging on about it and seize the opportunity to focus on what should be its real job (and with the FED still is). That is ensuring the health, the growth and full employment of a British economy which is flagging. These are now threatened by interest rates already too high and a pound substantially overvalued. In consequence we are running the biggest and longest sustained trade deficit in history. What does the Bank answer to this? We should ignore the travails of Euroland, which they’ve brought on themselves, recognise that if the dollar comes down we have to fall with it, even ahead of it, and set out to restore the competitiveness of our productive economy. Getting the pound down can only be done in the present context by reducing interest rates. Which you should even try even if by using one of your mini shifts which is excessively fiddly but does give a clear signal.
- Given that the British economy is flagging we need an expansion of demand. Only lowering interest rates can achieve this.
- The British economy is now characterised by a dominant financial sector based on credit and high levels of debt and sustained by rising house prices. Credit and house prices have now reached such high levels that they are unlikely to expand further in the near future. To manage such an economy by interest rates alone is like driving a high powered car on the brake and the accelerator but not using the steering wheel. If the government won’t manage the Bank must. Moreover the traditional recourse of bankers, higher interest rates, is not a viable instrument in this situation. With over extended credit and debt, ever higher rates punish, are painful and bring the danger of a wind down and a return to negative equity and repossessions. It only needs a small increase to tip us over that edge. We are very nearly there so don’t push. The only appropriate management tool in this situation is even lower interest rates to keep stimulating demand and growth until the productive capacity of the economy, which has been allowed to shrink far too far, is restored and can resume its traditional role of powering things forward. New times need new approaches. Sadly bankers are set in traditional ways and financial experts are obsessed with minutiae. Both make sense talking to a banking community. They are now deeply dangerous in this new world.
We do not mean to be apocalyptic but this position and this advice are the logical conclusion of the advice we have been giving to the MPC over the years. Now that we are at a turning point, and the way ahead is your old little by little up and down approach (though always more likely to move rates up rather than down) we think it is right to warn the MPC that with the end of the golden weather different strategies and a different approach are becoming necessary. The Bank controls the main lever of economic management and de facto in face of the fact that government is not prepared to manage in the old way it is the only agency capable of using it to steer the economy. Up to now the Bank has been concerned with micro management in the shape of petty fogging shifts in inflation. We hope that this is not the limit of its skills now that it should raise its gaze to wider prospects because an economy hung down with debt, which has shackled and weakened production, and can’t pay its way in the world, now requires a clearer view of objectives and a raising of the Bank’s game and aim. Without that we will limp behind the rest of the world whether it moves to growth or deflation when we should pursue British interests in the single minded fashion for which we now, uniquely in recent decades, still have the opportunity. |
