Stephen King: Monetary Puzzle Committee's move deepens debt problem

Spend today, perhaps, but now people should really start to worry about tomorrow

Perhaps the Bank of England's Monetary Policy should be re-named the Monetary Puzzle Committee. Last week's decision to cut interest rates by a further quarter of a point – the first such cut since 2001 – suggests that the Bank has become increasingly worried about the outlook for the UK economy. Yet the Bank's Governor, Sir Edward George, had only a few days ago castigated those "gloomsters" that were intent on talking the UK economy down. Could it be that the MPC itself has become infected by "gloomster-itis"? And, if so, why such a sudden change?

Perhaps more will be revealed this week on publication of the Bank's quarterly Inflation Report. To use its own words, the Bank's overriding objective is to hit its 2.5 per cent inflation target "over the medium term". Thus, it seems probable that the Bank believes that the ultimate risks to inflation are on the downside, despite higher inflation over the past couple of months.

And there are some potential justifications for this view. GDP in the final quarter of last year rose by a meagre 0.4 per cent, lower than is desirable and, if sustained at this rate, a reason to think that inflation might eventually undershoot the target. Recent business surveys have hardly been encouraging. The Purchasing Managers' surveys both for manufacturing and services – shown in the left-hand chart – have softened in recent months, suggesting that the apparent recovery seen in the middle of 2002 is fading rather too quickly. The UK's trading partners are also in some difficulty, potentially undermining the performance of UK exports. Meanwhile, the stock market's latest declines could have led to a renewed bout of nail-chewing within the Monetary Puzzle Committee.

There have also been plenty of bearish anecdotal stories about the UK housing market. Glancing through the pages of my local property rag, I get the impression that houses which, once upon a time, would have sold in the blink of an eye are now staying on the market for a long time. At this stage, however, most of this negative information on the housing market is no more than anecdotal. As the right-hand chart shows, on either the Nationwide or Halifax measure of house price inflation, prices across the country are still rising extremely rapidly, contributing to monster amounts of mortgage equity withdrawal and continued support for consumer spending.

So here is a central bank that accepts the difficulties of manufacturers, that recognises that growth is not quite strong enough, is worried about the weakness of the global economy, and is seemingly prepared to put the continued strength of house prices – at least on the official measures – to one side. On this basis, interest rates had to come down, thereby supporting the views of the gloomsters who had increasingly expressed concerns about the health of the UK economy over the past few weeks.

Yet, despite these ex-post justifications, last week's decision feels odd. There was a lack of transparency about the move. Typically, central banks like to guide consumers, producers and the financial markets through the wilderness that marks the long and winding path for interest rates. No need for sudden surprises, no case for tales of the unexpected. Surprise fosters uncertainty and uncertainty can have a nasty effect on the appetite for risk taking. When interest rates fell last Thursday, so did the stock market, losing more than 2 per cent of its value on fears that the Bank of England knew something nasty about the economy that other people had failed to spot. Surprise seems not to be a good thing.

Should the Bank be blamed for this lack of transparency? Clearly, the decision does not appear to be consistent with the "gloomster" comments that seemingly ruled out interest rate cuts only a few days earlier. Perhaps more fundamentally, the inflation targeting approach over-simplifies what is, ultimately, a very complex decision-making process. I would argue that the inflation targeting approach is almost impossible to get right, simply because it requires interest rates to be set at levels that may ultimately be inappropriate for all parts of the economy.

Should rates be cut to help manufacturers? Yes. Should rates be cut to help consumers? No. Should rates be cut when fiscal policy is being expanded and public sector job creation is keeping the unemployment rate at historic lows? No. Should rates be cut because of the collapse in the equity market and the associated loss of jobs in the financial sector? Yes. Should rates be cut because of the booming housing market? Definitely not. For each and every case for rate cuts, there appears to be an equal and opposite case for holding off. Under these circumstances, it is hardly surprising that people become confused about the Bank of England's intentions.

Moreover, although the inflation target appears to be a simple objective that, in the recent past, has been met with a great deal of success (if anything, the Bank has done rather too well, tending to undershoot rather than overshoot the magic 2.5 per cent figure), there is a significant complication, namely the time horizon over which the inflation objective has to be reached. As I mentioned earlier, the Bank hopes to hit its objective "over the medium term", not necessarily over the two-year period consistent with the forecasts contained within the Bank's Inflation Report.

The medium term, however, is an open-ended affair. We may be all dead in the long run but at least there's a (less than?) reassuring certainty about this observation. Heaven knows what's implied by the medium term. Not dead, perhaps, but lots of things may have changed in unexpected ways. And, because of this, I reckon that the inflation target is a lot more imprecise than either the Bank of the Treasury would like us to believe.

The simple point is this: hitting the inflation target in two years' time may be inconsistent with hitting the inflation target in five years' time. One way to demonstrate this proposition is to go back a couple of years, to the beginning of 2001, when the US was going into recession. To insulate the UK economy from global dangers, the Bank decided to cut interest rates in the hope that, by doing so, the consumer would carry on spending.

In some ways the policy was a success. As we all know, consumers were happy to dip into their pockets, flash their wads and swipe their credit cards. But one consequence of the policy has been a boom in house prices and a significant rise in consumer indebtedness. With the global economy having failed to recover, that rise in consumer indebtedness now presents a significant medium-term downside risk to economic activity. By attempting to keep the economy going in the short term in order to meet an ill-defined inflation objective, the risk is now one of severe inflation undershoots in coming years when consumers finally buckle under the weight of excessive debts and lower incomes.

And it is this dilemma that makes last week's move rather odd. Despite all of the rate cuts delivered by the Bank of England over the past couple of years, manufacturing has suffered an unpleasant demise. The only way in which rate cuts have worked is through consumer spending and the housing market. Unless the Bank is absolutely confident that the housing market is now weakening and consumer spending is softening, a rate cut now may simply exacerbate the debt problem that is already present in the UK economy. Spend today, perhaps, but I think now people should really start to worry about tomorrow in a quite serious way. Sadly, with the bursting of the global equity bubble of the late 1990s, we may all simply be worse off than we used to think: if the Bank is encouraging us to believe otherwise, there could be serious trouble ahead.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com