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Tiptoeing between the terrible twins of inflation and stagnation demands some fancy footwork from the Bank of England

by Tom Sieber

Depending on who you believe the 25-basis points rate cut by the Bank of England last week was either woefully inadequate or a blessed relief.

In a way this sums up the febrile nature of the economy at present. Where every piece of positive news is held up as evidence that a corner has been turned and any negative news portends an impending economic apocalypse.

And conflicting noises from the MPC about what its next move will be have not helped to clarify the situation.

Dresdner Kleinwort observes: ‘Over the past few weeks there have been a host of comments from MPC members – to the Treasury Select Committee, and individually from King and Tucker. What is striking looking at these presentations is that they have been evenly balanced, and certainly have avoided the gung-ho enthusiasm for more official action evident in the markets and the media. Perhaps policy makers always need to be more measured in what they say, but the concern about inflation comes across as being a genuine one for some members of the MPC.’

Taking a risk with rate cuts

Amit Thakar, a research analyst at Seymour Pierce, is sceptical about the Bank’s ability to affect a turnaround. He says: ‘Monetary policy, we believe, has become impotent. Credit conditions globally have only improved when fiscal policy has come into play – be it the bailing out of Bear Stearns or by an expansive fiscal policy. We believe the BoE is taking a risk. If it keeps on cutting and credit conditions do not improve, sterling could depreciate quite rapidly. Older readers will remember what a sterling crisis could do.’

Grim reading. Particularly as there is little capacity in the UK for a fiscal solution to the current problems.

Problems that have now, without question, become historically significant. According to a report from the Royal Institution of Chartered Surveyors (RICS) house prices are seeing their most widespread decline since they began compiling the data 30 years ago. According to RICS spokesman Jeremy Leaf: ‘The slowdown in prices is directly attributable to a lack of available finance which has hit demand.’

This, perhaps, explains the reaction to the MPC decision from Stuart Law, head of property group Assetz. He says: ‘Finally, the Bank of England has taken action and sanctioned a much-needed cut in interest rates. However, I fear this is not enough and very late – a more significant cut of 0.5% was needed if it was to have any impact on the market.

‘A growing number of lenders are now pricing themselves out of the market with uncompetitive deals and this is not healthy. The Bank not only needed to cut rates but it needs to inject some much needed liquidity into the market – before competitive mortgage deals all but dry up.’

As Law suggests the situation has been exacerbated by the reluctance among the banks to pass on the cut in the base rate to lenders – prompting a war of words between Number 10 and the industry, with the latter bemoaning the lack of liquidity.

Brian Hilliard, Societe Generale’s director of economic research, believes the Bank has a responsibility to tackle this issue. He says: ‘The pound has fallen by 13% in trade-

weighted terms since last July. This will be an increasing concern and the Bank is now regularly highlighting its effect on import costs... This will temper its ability to react to the liquidity problems through more aggressive rate cuts. Moreover, Libor is starting to fall, albeit modestly. What we need to see instead is some greater direct liquidity measures and we think the Bank must soon take more radical action to address this issue.’

At the same time the spectre of inflation has not gone away, with the World Bank highlighting the catastrophic effect of rising food prices last weekend. Of course the problems in the UK are likely to be far less acute than those in developing and third-world countries – but it will obviously be in the minds of the MPC members – especially with factory-gate prices rising at the fastest rate since 1991.

A cycle of fear

Robert Bryant-Pearson, from leading chartered surveyor firm Allied Surveyors, believes though the rate decision ‘signals that the fear of a recession is greater than the fear of inflation... Inflationary pressures are not consumer led, but are because of price-push inflation caused by oil prices and the strong euro.’

The withering response to the Bank’s actions last week reveals what a difficult course it has to steer in the current environment. Our sympathy should be constrained – the people involved are well paid to make these decisions – but at the same time it is hard to see how they can get it right. Cutting interest rates is having little impact on the credit crisis and increases the risk of inflation and, potentially, a devaluation crisis. Furthermore, an injection of liquidity may still not be enough to restore confidence.

In the circumstances it seems likely that the Bank will have to take the latter option sooner rather than later and the minutes from this meeting, released next week, will make interesting reading.