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Should the MPC have cut rates sooner?

Created:

6 January 2009

Updated:

7 January 2009

Written by:

Jonathan Eley

When the Bank of England's monetary policy committee meets this week, it's almost certain that it will agree another deep cut in base rates, taking them down to their lowest level ever. Such decisive action will doubtless be welcomed by industry and government. But could the MPC have avoided being in this position by starting to cut rates sooner, rather than being preoccupied with the threat of inflation?

YES, says John Stewart, director of economic affairs at the Home Builders Federation:

"Sadly it is now clear that, to have had the desired effect, cuts in Bank Rate were needed months earlier than they were made - and that is not just us being clever with the benefit of hindsight. HBF lobbied from early 2008 for a large cut, as we felt that many key indicators were there for the MPC to read, but were regrettably ignored for far too long.

The housing market, so absolutely critical to the wider economy, was showing signs of serious decline from autumn 2007, and by 2008 was in an unprecedented downturn, meaning it was inconceivable that our economy could continue to grow unhindered. An interest rate cut in early 2008 could have supported the market and thus helped reduce subsequent house price falls and large-scale redundancies in the housebuilding and related service industries. The delay in cutting rates allowed a vicious circle to develop in the housing market of falling volumes, falling prices and weakening confidence among buyers, valuers and lenders.

Of course the MPC will say their remit dictates that inflation was their main concern. But with the US and UK economies floundering, surely they should have seen that the commodity and oil price booms fuelling inflation were unsustainable?

The collapse of Lehman Brothers in September of last year finally sparked the MPC into action as the banking crisis became acute. But the warning signs had been there a full year before with the fall of Northern Rock. The credit crunch and housing downturn had been undermining economic activity long before September 2008, as evidenced by the sharp third quarter GDP fall.

To me, the combined crisis in the housing market, banking sector and economy, all interlinked, dictated that deeper rate cuts had to be made earlier. We felt the indicators were quite clear and thus we were very vocal throughout the year on the need for cuts. One MPC member, David Blanchflower, shared our concerns. Unfortunately his colleagues did not take his (and our) warnings seriously enough and the opportunity to make an effective early intervention was missed."

NO, says Chris Dillow, economist at Investors Chronicle:

With hindsight, everything seems inevitable even if at the time it looked unlikely.

The fact is that, if we cast our minds back to last summer, there were good reasons for the Bank to hold rates at 5 per cent. As recently as August, economic forecasters expected CPI inflation to remain over 2 per cent into 2010 and beyond. The consensus, then, implied that a 4 per cent Bank Rate was if anything too low, not too high.

Of course, neither outside forecasters nor the Bank realised then that the economy was in recession. But, even if they had, it would have been hard to cut rates much. With oil prices over $100 a barrel and households' inflation expectations high, inflation might have stayed above target even as the economy faltered.

Nor could the Bank have foreseen that the financial crisis would sharpen so much in September with the collapse of Lehman Brothers. The surprise here was not so much that Lehmans failed, but that the US Treasury let it do so, having engineered bailouts of Bear Stearns, AIG, Fannie Mae and Freddie Mac. Such a capricious decision triggered a financial panic that has deepened the global downturn. But no one saw it coming.

Still less could the Bank have anticipated the fall in commodity prices. The 60 per cent drop in oil prices since mid-August is a three standard deviation event. You can't set interest rates on the basis of such low probabilities.

You might object that one MPC member - David Blanchflower - did urge a rate cut in the summer. But this only raises the question: why did he fail to persuade others? Either his rhetorical powers are feeble or, more likely, the evidence for his case was patchy, and seems convincing only with hindsight.

The truth is, the idea that the Bank should have cut rates earlier rests upon a false and dangerous assumption: the notion that the future is foreseeable and so forecasting errors are blameworthy. Rather, the fact is that the future is inherently unknowable, and decisions that rest upon it - be they setting interest rates or buying shares - are just as likely to turn out to be 'wrong' with hindsight. It's time we learned to live with this, and stopped chasing an illusory predictability.

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