FT Money Comment piece – Rate cut dangers – beware inflation

by Dr. Ros Altmann

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Many savers and pensioners have suffered heavily as a result of the Government's crisis policy measures. Interest rates have been cut to unprecedented levels and most cash savings accounts now pay depositors little or no income, compared with around 5% interest rates just a few months ago.

Irresponsible lending, borrowing and investing in recent years have undermined the economy, as over-indebted households and banks on the verge of bankruptcy must now retrench. Yet the authorities are desperately trying to revive activity by encouraging banks to lend and people to spend.

There seems a real injustice here, as money is taken from older savers who behaved responsibly, to be given to younger borrowers and to the banks themselves - the very groups whose actions caused the problems in the first place.

I believe rate cuts have gone far too far. Indeed this is yet another example of misguided short-term policymaking which will worsen the economic outlook by penalising saving, damaging pensioner incomes and heralding high inflation.

Standard economic theory suggests that lowering interest rates is expansionary, but this is a very crude weapon for economic stimulus. It relies on banks making cheaper loans available to businesses and consumers. However, as banks are struggling with bad debts from past loans and investments which may never be repaid, they have reduced lending and increased their margins by pocketing some of the rate cuts, rather than fully passing them on. So, falling rates benefit banks more than borrowers, thus diluting any economic stimulus.

In fact, there is a significant risk that cutting rates too far, too fast, will make the situation worse. One of the essential features of a successful economy is confidence. Continuous panic policy measures undermine consumer confidence, which will reduce spending.

Rate cuts also act like a substantial tax increase for the millions of pensioners who rely heavily on savings interest. Their incomes have been slashed. This is not expansionary - it is little different from cutting the state pension. If half of Britain's 12 million pensioners have £10,000 of savings, recent rate cuts imply £10 a week less income, costing them £3 billion a year. All other savers have suffered too.

Additionally, there is a serious risk that rates reducing rates so dramatically is sowing the seeds for inflation problems after 2010. Monetary policy operates with a lag and past rate cuts take time to feed through to the economy.

Of course, many commentators justify current low interest rates by arguing that real rates are declining as inflation falls. I believe such arguments about deflation are misguided. Price falls this year are mostly a short-term temporary statistical phenomenon due to the base effect of sharp price rises in 2008 and December's VAT cut. Annual inflation is still positive and deflation is not a general reality. For most pensioners, inflation is still rising while their income has fallen. For example, food and non-alcoholic drink prices rose 10.4% in the year to December 2008, housing and household services rose 14.4% and council tax bills have increased again.

Of course, much of the analysis forecasting deflation comes from bank economists with notoriously short-term time horizons - far shorter than policymakers should respond to. Banks also have a vested interest in painting a bleak picture in order to encourage more monetary stimulus to boost their businesses. However, longer-term analysis would suggest that, in fact, after temporary price falls in 2009, inflation is a greater danger than deflation.

Worryingly, it will be almost impossible to increase rates again in time to avoid a huge inflationary shock in coming years. Can we really imagine interest rates rising sharply as soon as signs of an upturn appear? Dramatic rate cuts, printing money to offset bad loans, and pumping billions into the failed banking system are all storing up inflation for the future. This will hurt savers again.

I think the authorities have already decided that, politically, inflation is the least painful way to repay debts, so the assault on long-term investors and pensioners seems relentless. First, sharp falls in the stock markets wiped out a substantial amount of their savings. Then those who put assets into 'safer' areas such as cash have seen their interest income disappear. And next, the real value of their savings could be eroded by inflation. Yet more dreadful news for pensioners. And still no end in sight to our economic problems.

So, if lower rates won't help, what could be done? Well, aside from waiting for the effects of monetary easing to work - and sterling weakness will certainly help attract overseas buyers to spend money in the UK and provide some economic stimulus - the Government probably needs to directly intervene to get loans to viable businesses more quickly. The feedthrough mechanism from rates to lending is blocked at the moment, as financial institutions struggle with previous failures. A Government sponsored lending body, rather than relying on banks, would be more effective.

Fiscal action is also needed. Why not bring back the 10p tax rate, instead of the ineffective cut in VAT? Also, how about radically reforming the state pension to improve pensioners' incomes? Government should take charge, organise direct lending to viable private businesses, and the authorities should resist creating an inflationary crisis via more monetary easing.


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