by Dr. Ros Altmann

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5 reasons why rate cuts will damage the economy now:

Most commentators are expecting rates to be cut again by the Bank of England tomorrow. I urge policymakers to think again. Rates are already too low and cutting them again will just make most people worse off. Panic cuts are not the answer, they may give easy headlines for politicians desperate to 'do something' but they have gone beyond the point of being helpful. There are only a million mortgage holders with tracker mortgages, the rest of mortgage holders will benefit little, if at all and all savers will be hurt yet again.

Standard economic theory suggests that lowering interest rates is an expansionary policy. Rates have been cut from 5.5% to 1.5% in just a few months, but it seems the economy is still weakening. My view is that cutting rates so far, so quickly has weakened the economic outlook, not improved it. Cutting rates yet again will make things even worse. Confidence will fall again, pensioner poverty will rise further and spending will suffer.

Panic measures can cause normal economic relationships to break down. Policymakers are desperately trying to boost the flagging economy, encouraging more spending, lending and borrowing, to fight the spectre of depression. But lower rates are a very crude weapon. They punish those who actually did the right thing, while benefiting the very groups (the banks in particular) whose actions caused the mess in the first place. We should not ignore the collateral damage on innocent civilians of cutting rates so far, so fast.

So why is cutting rates - again - so harmful?

1. Undermine confidence: Such dramatic cuts undoubtedly undermine confidence and damage consumption. When they see policymakers panicking, people reduce spending and retrench, fearing worse to come. This negative effect far outweighs the positive possible impact of encouraging already over-indebted consumers to borrow and spend more by lowering interest rates.
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3. Not given time for past cuts to work yet: We have not given previous cuts sufficient time to take effect. Monetary policy operates with a lag. The fact that the economy is still weakening does not necessarily demand further rate cuts. If a patient fails to show early signs of recovery, the sensible doctor will either give the medicine time to work, or change the treatment, rather than desperately doubling the dose. An overdose could even prove fatal. The same may apply to rate cuts, however frustrating that might be for policymakers and politicians who want to 'do something'!
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5. Damage to savers and pensioners: Rate cuts, in practice, act like a substantial tax increase for pensioners. This is not expansionary - it is the equivalent of a cut in the state pension. Millions of pensioners, who rely heavily on savings interest, have seen their incomes slashed. Indeed, pension credit means-tests still assume pensioners are earning 10% (yes, 10%) interest on their savings. This pushes more into poverty, damaging consumption. If half of Britain's 12 million pensioners have £20,000 of savings, recent rate cuts imply £20 a week less income, costing them £5billion a year.
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7. May not work anyway! There are no guarantees that lower rates will boost lending - the classic case of 'pushing on a string'. So far, cuts have often not been fully passed on as lenders increase margins, and raise charges on loans. This means businesses and households are still struggling with both availability and affordability of credit. Interest rates are not the main problem.
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9. Huge inflation risk: Although the consensus suggests we are heading for deflation, this could well but just a temporary phenomenon. Falling prices are a statistical inevitability after the sharp increases in 2008, but this does not necessarily mean depression. In fact, inflation is a far greater danger than deflation. I believe the authorities have already decided that, politically, this is the least painful way to repay debts. Monetary policy should not be worsening the situation. It will be almost impossible to increase rates again in time to avoid a huge inflationary shock some time in the next 2 or 3 years. Of course the economy is facing at least another few months of severe economic pain. But the financial sector will remain weak for far longer than that. It will fight to retain easy monetary conditions, even when that would not be appropriate for the rest of the economy. Politically it will be enormously difficult to judge when the stimulus has worked and the risks of inflation outweigh recessionary trends. That will again hurt innocent savers who will see the value of their savings slashed once more, this time by inflation.
   
   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 - the Government probably needs to take direct charge of lending to banks. We need businesses to be able to access loans, but banks are not lending. For the moment, then, it would be far more effective for policymakers to directly target business lending with some temporary public lending.
   
   The feedthrough mechanism from rates to lending is blocked at the moment, as financial institutions struggle with previous failures. Direct intervention, probably via a Government sponsored lending body, rather than relying on banks, would get loans to viable businesses more quickly. This route could also help those at risk of repossession by buying housing assets from mortgage-holders in default and allowing them to remain in their homes. They could perhaps pay some money in rent and it would be cheaper than moving and having to be rehoused by local authorities.
   
   This crisis was caused by excessive focus on short-term growth and misunderstanding of financial risk. Debtors, particularly those who were highly leveraged, cannot service their debts. Many banks are really bust. Encouraged by abnormally attractive financing arrangements, lax regulation and complex risk models that failed to properly reflect risk, financial institutions have lent, borrowed and invested irresponsibly. Most Western economies have been living beyond their means for several years, effectively borrowing money from the future. Demographically, this is a disaster. Dramatically falling birth rates after the post-war baby boom mean insufficient younger cohorts to produce future growth. Yet they will shoulder the repayment burdens as millions of those older workers are about to leave the labour force. Increased borrowing will worsen the payback problems, and lower rates will damage spending power of the fastest growing group in the population.
   
   So the conclusion is that fiscal action is needed, not further monetary easing. We also require urgent radical reform of both pensions and retirement to cope with demographic drag. Government should take charge, organise direct lending to viable private businesses, and the Bank of England should resist aggravating the coming inflationary crisis via more damaging rate cuts.

Dr. Ros Altmann
07799 404747

ENDS