Hamish McRae: Bank must reshape its role to ensure monetary and fiscal policy are in tune

So what will the next five years hold for Mervyn King? His reappointment took on a certain spice after the Northern Rock debacle but in reality the Government now is too weak not to have confirmed that he would stay.

Think about the way Gordon Brown would have had to temper every self-congratulation about giving the Bank its independence if the principal architect of the country's monetary policy over the past decade were to be shown the door. Besides, there was no other obvious candidate. But it was an appointment made through gritted teeth. The Chancellor is known to be deeply critical of the Governor's performance over Northern Rock, believing that he is too much of an academic and not enough of a banker, a view echoed in the City. It must be all the more galling to realise that, on the balance of probability, Mr King will still be in his job when the Prime Minister and the Chancellor are no longer in theirs.

Jolly enough stuff, but not actually very important: the politics of the reappointment matter much less than the reality of what will be a not-so-nice five years. (The NICE decade – non-inflationary consistent expansion – was how the Governor characterised the 1995-2005 period.)

Why not so nice? Well, the next five years are likely to see an international economic downturn, a domestic housing downturn, a squeeze on real incomes, and tough fiscal situation for the Government. Some words about this disagreeable combination and then some thoughts about how the Bank should respond.

The first point to make is that there is such a thing as the global economic cycle. The first graph, taken from the International Monetary Fund, shows how global growth has fluctuated since 1950. It would be pretty odd were that pattern to disappear. But since the 1970s, the amplitude of the cycles seems to have diminished a little, suggesting that the next downturn may be quite mild. Just this week, we have had new forecasts from the IMF, with a below-consensus forecast of 1.5 per cent growth for the US. That is consistent with the GDP figures out yesterday, showing very slow growth in the final quarter. But the rest of the world is still expected to do reasonably well and the Fund reckons that global growth next year will still be 4.1 per cent, down from the 4.9 per cent last year but a long way from the troughs of previous cycles.

However, I don't think that changes the core proposition that at some time in the next five years there is likely to be a slowdown analogous to the ones of the early 1980s, early 1990s and early 2000s. So this will come on Mr King's watch.

Now to the domestic economy. The graph plotting mortgage approvals and retail sales was sent to me by Royal London Asset Management, whose economist Ian Kernohan notes that this bodes ill for retail sales. Retail sales dipped in 2005 but quickly rebounded. If, as the derivatives markets suggest, house prices come down by about 7 per cent this year, they will not rebound so swiftly. Yes, the Bank's Monetary Policy Committee will cut rates and that will ease the squeeze a little. But debts have to be repaid as well as serviced and the proportion of people's income going in debt service is now as high as in the early 1990s, even though interest rates are much lower, as the third graph reminds us.

Conclusion: if you want to be alarmist, as the Financial Services Authority seems to be nowadays, more than a million homeowners are at risk of being in serious financial difficulty and possibly losing their homes. According to the FSA, people who have borrowed more than three-and-a-half times earnings or have borrowings of more than 90 per cent of the value of their homes are at risk. I happen to think that is a pretty silly thing to say, or at least a silly time to say it. The time to make that point was when the lenders, such as Northern Rock, were offering mortgages of more than 100 per cent and offering up to six-times salary. The FSA should have made that clear then and examined the books of the lenders that were following such practices. It is prattish to make the point now. What our homeowners face is a slog to get debts under control and they need practical guidance on how to do so, not this alarmist rear-view-mirror stuff.

Actually, the public sector's borrowing is rather more alarming than the private sector's. That is not the direct concern of the monetary committee but fiscal policy inevitably shapes monetary policy. Yesterday, the Institute for Fiscal Studies' wonderful "Green Budget" came out – really the best bit of analysis of the UK fiscal policy that there is. The headline is that the Government will either have to raise taxes, cut public spending plans, borrow yet more, or some combination of all three. But the underlying issue here is that the Government's fiscal premise – that growth will remain steady – is a dangerous one. Make some less favourable assumptions about growth and public borrowing, far from coming down, will shoot up.

That creates problems for monetary policy. The more the Government borrows, the smaller the pool of savings there is available for the rest of the country to borrow. In recent years, there has been little or no "crowding out" of the private sector but there have been periods in the past when that was so. Interest rates formally have to be set to try to contain inflation within the limits set by the Government: around a middle point on the CPI of 2 per cent. But we have learnt – or at least I hope we have learnt – in the past five years that asset prices and financial stability matter too.

The official job of the mon-etary committee may be the narrow one of targeting inflation, but the wider role of any central bank is the one of maintaining stability. This is separate from the initiative announced by the Chancellor yesterday, which is essentially how to patch up better if things go wrong. A more stable financial environment would reduce the chances of banks needing to be rescued in the first place.

And that surely is the task for the next five years: how to reshape the Bank's role, so that alongside the broadly successful work of the monetary committee, it shows that it has a wider vision. We got monetary policy right but we got financial stability wrong. The European Central Bank seems to understand that you have to do both, though it has a particularly difficult task reconciling the needs of very different economies. In the end, it will fail to do so. The Federal Reserve is struggling, after what is now clear were catastrophic mistakes on both counts by the previous chairman Alan Greenspan, and being pushed into panic interest rate cuts. Here we have a difficult balancing act but we also have the chance of tuning both monetary and fiscal policy so that they work in reasonable harmony, despite the obvious tensions noted above.