Investment Management Blog - Montague Capital

If it were the only set of data that needed to be considered, the Bank of England’s quarterly survey of credit conditions, published yesterday, would be pointing to an imminent cut in interest rates.  After contemporary evidence in the last few days from individual lenders about the price and quantity of new loans on offer (or not as the case may be), the Banks’ survey showed that 42.5% of lenders propose to cut secured credit in the next three months compared with only 25.3% in December.  The excuses offered by lenders for this greater caution are not surprising: difficulties in raising money in wholesale markets, “risk is not good any more”, and a growing expectation that the housing market and the economy are going down.

What the banks seem to have trouble getting their heads around is that, by not lending, they only stand to make the situation worse for themselves.  Take away the monetary fuel that has powered house prices up to unsustainable levels and buyers find they can’t afford what sellers want.  Sellers, when they see a “good” price slipping from their grasp, become less choosy.  Buyers, seeing sellers blink like this, have no reason to become less aggressive but rather discover a bit of bargaining power.  And so it all spirals down.  What about the “value” of the mortgage book then and of all the paper created on the back of it?  Unfortunately, this may be an inescapable reality whatever happens to interest rates.  The IMF’s World Economic Outlook calculates that UK house prices are 30% higher than can be justified by incomes, monetary conditions and demographics.

The “fix” being demanded by the monetary doves is to cut interest rates.  This is miraculously supposed to make everything affordable once more.  We can all look forward once again to TV schedules filled with programmes about where to buy our third overseas holiday home and how to gold-leaf the dining room wall.  Well, that hasn’t worked so far and there’s little reason to believe it will now.  Just look at the US, where even a halving of interest rates to an inflation-busting 2.75% has achieved squat-diddly.  For as long as banks refuse to lend to each other and every interest rate cut seems to bring instead a corresponding increase in the spread of LIBOR over base rate, there’s almost no point in easing policy.  Forcing banks to lend by regulation would be much more effective than just cutting rates.  Use the emergency credit, or lose it.

The doves insist, and with justification, that it is important to restore confidence.  If cuts in interest rates can convince us all that Alastair Darling is right after all and UK plc is not heading for recession, everything will go straight back to normal.  Which is when we remember the elephant in the corner of the room.  The 1997 Bank of England Act mandates the pursuit of a 2% inflation target, with a band of ±1%.  It does not mandate an economic growth target.  CPI inflation is already running at 2.5% (RPI about 2% higher) and rising inexorably thanks to higher food and fuel prices.  Give households, companies and banks the impression that inflation doesn’t matter and inflationary expectations will let rip.  Whereupon interest rates go up at a much faster rate than they have recently been coming down, bringing about the very recession everybody is now so keen to avoid.

The Bank of England has an unenviable task.  Pushing on a piece of string now in a probably futile attempt to help banks rediscover an appetite for risk, or crippling the economy later when it tries to rein inflation back in.  (Remember interest rates in the 1990s?)  One month’s data from the Chartered Institute of Purchasing and Supply to the effect that the service sector is feeling the squeeze does not justify easing monetary policy, especially when the CIPS’ own input price series now stand at its highest level for twelve years.

In the greater scheme of things a cut of 0.25% would be a purely cosmetic gesture (and waiting just one month would hardly hurt either), but this unnecessary expenditure of ammunition today may come to be regretted later.  There are potentially bigger problems to come which will be hard to deal with if interest rates have already been slashed to next-to-nothing.  The Bank’s survey of credit conditions also shows unsecured credit rising rapidly.  Could it be that households are turning to their “flexible friends” to pay the mortgage and other basics?  And when they fall behind on their credit card bills which will they choose to be the first to go: the plastic or the house?  No-one is really factoring in credit card delinquencies yet to banks’ business forecasts.  Getting the sub-prime fallout right is bad enough.  But the UK in the leading country in the OECD’s for household debt.

Behind it all there will be a sense of where UK plc deserves to be, which is not where it was in the unsustainable and now clearly unhealthy debt-fuelled conditions that prevailed barely a year ago.  We are unlikely to be hearing “You’ve never had it so good” for a few years yet.