Latest rate cuts will lead to inflation, won’t solve the problems and are unfair

by Dr. Ros Altmann

(All material on this page is subject to copyright and must not be reproduced without the author’s permission.)

---

The Bank of England has cut interest rates – again. I fear this is yet another policy mistake and, as I warned you all a few weeks ago, such low rates could make the economic outlook worse, rather than better, for millions of us. Inflation is now a real danger next year.

More panic rate cuts are not the answer to our economic woes. The authorities are desperately trying to boost the flagging economy and encourage more spending, lending and borrowing. But is this really the right response to a crisis caused by too much irresponsible lending and borrowing by banks and individuals? And, even if it is, will such dramatic rate cuts actually deliver the desired effect? The answer to both these questions is ‘no’.

Lower interest rates are a very crude weapon for economic stimulus. The policy relies on banks passing on rate reductions to borrowers, and making cheap loans available to increase business and consumer spending. However, as banks are struggling with bad debts from past loans and investments which may never be repaid, they have pocketed some of the rate cuts, rather than passing them on fully to borrowers and have also raised loan charges. In effect, the rate cuts benefit banks far more than borrowers which dilutes any economic stimulus.

There also seems a real injustice here, as money is taken from older savers to be given to younger borrowers and to the banks themselves. Cutting rates takes money away from people who have behaved responsibly and gives it to the very groups whose actions caused the mess in the first place. I am sure we will look back on this period and realise that the authorities have gone too far.

Worryingly too, rather than providing a stimulus, these panic cuts could actually worsen our economic problems. One of the essential features of a successful economy is confidence. If consumers are fearful, they will not spend. The constant sight of panicking policymakers undermines confidence, and causes people to reduce spending. This negative effect far outweighs the positive possible impact of trying to help already over-indebted consumers to borrow and spend more by lowering interest rates.

Secondly, millions of pensioners, who rely heavily on savings interest, have seen their incomes slashed, which will increase pensioner poverty. Cutting rates is like cutting the state pension. There are 8 million pensioners with savings, most of whom are likely to spend less now than they would have done. This will weaken the economy, not strengthen it.

Thirdly,we have not given the past rate cuts time to feed through to the economy. Monetary policy operates with a lag. Continued economic weakness does not necessarily demand more rate cuts. There was already huge monetary stimulus in the pipeline but it takes time to work. The big risk now is that, by pushing too far, we have sown the seeds for a huge inflation problem after 2010. Dramatic rate cuts, printing money to offset bad loans, and pumping billions into the failed banking system are storing up inflation for the future.

Of course, the current talk is that we are heading for deflation, but I believe such concerns are misguided. Price falls this year are mostly just a short-term temporary statistical phenomenon after the sharp price rises of 2008 and the VAT cut.

But, much of the economic analysis that is forecasting deflation is being carried out by bank economists who tend to operate on very 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.

More independent and longer-term thinking would surely show that, in fact, after the statistical base effect of falling prices in 2009, inflation is now a far greater danger than deflation. The concern is that 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.

Obviously, 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 and will fight to retain easy monetary conditions, even when that would not be appropriate for the rest of the economy. Can we really imagine interest rates rising sharply as soon as signs of an upturn appear?

I suspect the authorities have already decided that, politically, inflation is the least painful way to repay debts. This will hurt savers again. 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 and bonds have seen their interest income disappear. And next, the real value of their savings could be eroded by inflation.

I urge the Government to take the plight of savers seriously. As we are heading for far more older members of society, what will they live on? It seems savers are being fined for having saved and the responsible majority are substantailly worse off than they were just a few months ago. This is sending very dangerous messages to future generations.

My conclusion is that we urgently need a more joined up approach to helping the economy. Government should take charge and, instead of hoping lower rates will eventually kick-start lending by bankrupt banks, it should lend directly to viable private businesses to get money to where it is needed quickly. Fiscal action – such as bringing back the 10p tax rate – would be far more effective than further monetary easing and the Bank of England should resist aggravating the coming inflationary crisis via more damaging rate cuts.