Congratulations must go to the MPC

By Martin Wolf

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Sometimes boldness is caution. The Bank of England’s monetary policy committee has, in extreme circumstances, adopted the “risk management” approach followed by Alan Greenspan and Ben Bernanke at the Federal Reserve. It was right to do so.

In my column of last Friday (“What the British authorities should try now”) I recommended a cut of two full percentage points. The MPC has not gone quite that far. But it is to be congratulated for coming as far as it has, with its one and a half percentage point cut bringing rates down to 3 per cent, their lowest since 1955.

In making this decision, the MPC recognises that an already disturbing economic story changed dramatically for the worse with the financial shocks of September and October. As the MPC stated on Thursday: “Since mid-September, the global banking system has experienced its most serious disruption for almost a century.”

Meanwhile, it added: “In the UK, output fell sharply in the third quarter. Business surveys and reports by the Bank’s regional agents point to continued severe contraction in the near term. Consumer spending has faltered in the face of a squeeze on household budgets and tighter credit. Residential investment has fallen sharply and the prospects for business investment have weakened. Economic conditions have also deteriorated in the UK’s main export markets.”

Thus the risk has shifted from inflation to deflation. While a short period of falling prices would be no disaster, entrenched expectations of deflation would be, particularly for a country as over-indebted as the UK. Debt-deflation is a plague to be avoided at all costs. This is why the inflation target is symmetrical.

‘In present circumstances, the risks of doing too little are far greater than those of doing too much’

Yet will this cut work? The answer is that it is unlikely, on its own, to lead to a sudden resurgence in lending. But, in conjunction with the other measures taken – recapitalisation, guarantees on new lending and liquidity provision – it should help the slow healing of the banking system.

Part of that healing consists of rising margins on lending, partly because profitability must be restored and partly because spreads were far too low prior to this crisis. Banks will not cut lending rates by the same amount and should not do so. But lending rates should now fall and the availability of credit start to improve.

Is the cut too risky? The answer is that in present circumstances, the risks of doing too little are far greater than those of doing too much. Nonetheless, risks do exist. In particular, sterling may come under severe pressure. If so, inflation might turn out to be much more persistent than now seems likely.

Yet, on balance, it was right to ignore this danger. It is even possible that the combination of strong policy action with the hope of a smaller recession than otherwise will strengthen confidence in the UK economy and in its management. If so, sterling may even strengthen.

It remains vital, however, for the long-term credibility of the policy regime to be sustained. This must be seen as a move against the risk of deflation, not as a step towards inflation. With the Bank willing to take such powerful moves, the case against large discretionary fiscal stimulus also becomes weaker.

Finally, will this cut be enough? This is almost certainly not the end of the cuts. Some downturn was necessary and inevitable at the end of such a vast credit boom. But a huge recession must be avoided. So I would guess that further cuts will come. Even the UK might end up testing the zero bound on interest rates. Let us hope not. For, if so, economic conditions would be dire indeed.

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