Why rates should come down next week

By DAILY MAIL REPORTER
Updated: 11:28 EST, 6 October 2008

The Daily Mail's City Editor says it is time Mervyn King switched his crosshairs from lowering inflation to stimulating the money markets...

Time to change targets: Alex Brummer, City editor

Pressure is building on the Bank of England to deliver a decisive interest cut to ease the banking crisis and prevent Britain falling into a devastating recession.

The interest rate-setting Monetary Policy Committee starts a two-day meeting next Wednesday amid signs that the UK economy is in danger of going into freefall.

The overwhelming case for cutting rates is that it might ease the tourniquet gripping the money markets, where banks lend to each other, and could give a fillip to consumer confidence.

Marks & Spencer chairman Sir Stuart Rose told me yesterday that even if such a cut has no material effect on the cost of borrowing now it would signal to the consumer that 'rates have peaked' and are on the way down.

The nine members of the Monetary Policy Committee have never been as divided as in recent months as to what is the greater enemy - inflation, or the dangerous conditions in the credit market bringing with them the risk of slump.

In the last few days, as the banking crisis has intensified in Britain, across Europe and in the US, several members of the MPC including the deputy governor Sir John Gieve have indicated that an interest rate cut might be helpful.

The Government, under intense pressure to guarantee a crumbling banking system, would also welcome more help from the Bank of England.

Governor Mervyn King has been steadfast in seeing inflation as the main enemy and has held the bank rate at 5% since it was cut by a quarter point in April this year.

To have any real chance of changing the psychology of the financial markets a decisive cut of at least half a point is seen as necessary, although even a quarter point reduction would at least signal a change in attitude.

A cut in official interest rates would make it slightly cheaper for banks to borrow some funds from the Bank of England. This might also nudge down market interest rates.

However, diminishing competition in the home loans markets, as lender after lender is absorbed into a bigger bank, means that the pressure which banks and buildings societies used to feel to pass on interest rate cuts is no longer as intense.

There had been hopes that the Bank might have drawn some encouragement to ease rates by the European Central Bank. But at its latest meeting in Frankfurt it decided to hold its key rate at 4.25%, despite the credit crunch and increasing signs of a Euroland recession.

The decision reflects the ECB's policy of always seeing the fight against inflation as the paramount battle-It will be quite difficult for the so called 'hawks' on the Monetary Policy Committee, those who always put the fight against inflation first, to ignore the example of the ECB. They might also be somewhat alarmed by the latest International Monetary Fund forecasts which suggest that the commodity price explosion is not yet over and there are still inflationary risks for many countries.

But global demand for commodities and goods is dropping fast, as the credit crunch impacts on every aspect of consumption.

The ECB decision not to cut its rates suggest that hopes of a coordinated interest rate cut, designed to ease tensions in the banking system, are now less likely.

However, the Bank may well receive some help from the Federal Reserve in the US which is actively considering a cut in its key rate from 2%, if and when the $700bn bailout package is passed.

Historically, aggressive cuts in interest rates have been regarded as the best inoculation against allowing a deep recession to become a slump.

Until the last week or so most City economists took the view that the battle against inflation needed to won before rates were cut aggressively. But the markets have been so scared by the tumultuous events in the banking sector that the luxury of hanging on, for a victory over inflation, can no longer risked.