Should falling inflation yield a rate cut?

Last week, the Office for National Statistics surprised economists by announcing that the Consumer Price Index (CPI) had sunk to 1.3 per cent for December – a full 20 basis points lower than City expectations, and also the November equivalent.

Driven largely by increased discounting among high street retailers and a fall in hotel prices, inflation is now at its lowest level in over three years. And, according to the latest forecasts, this downward trend looks set to continue.

For consumers, it ostensibly represents good news, with their pound going further. Yet there is one potential consequence of weak inflation data: an imminent cut to interest rates. As ever, we remain unconvinced this would be beneficial to Britons, and indeed the wider economy.

The case for a cut

Next Thursday sees the Monetary Policy Committee (MPC) convene for the first time this year, and various members of the rate-setting panel have indicated in the media that they favour a ‘prompt’ rate cut in the face of the aforementioned inflation numbers, along with a slowdown in economic activity. 

A fortnight ago, we learned that output in November actually shrunk by 0.3 per cent, with the manufacturing sector coming in for significant punishment, and even the powerhouse services sector showing signs of wavering.

It should also be remembered that the Bank of England’s core remit is to keep the CPI in and around its target of 2 per cent. As such, it is understandable that MPC members are agitating to wield the axe on borrowing costs next week. It would have the dual impact of reversing the current downward pressure on inflation, and provide stimulus to the economy. So what’s not to like?

The case against a cut

The problem is base rates are already within touching distance of all-time lows at 0.75 per cent, so it follows that the limited degree of monetary policy firepower that remains should be used wisely. And there are good reasons to believe that now is not the time.

First and foremost, we should remember that both inflation and GDP data are retrospective, and we should consider the climate at the time. Back in November, and into December, the economy was racked with uncertainty in the build-up to the General Election, with zero clarity on taxes, our future trading relationship with Europe, and everything else in between. 

The Conservative majority which eventuated on 12 December – although not to everyone’s liking – at least removes a large chunk of this uncertainty, and there is already anecdotal evidence that a ‘Boris bounce’ has kicked in. Business confidence has increased over the past month, while data from Halifax suggested that house prices picked up in December. And global trade tensions have been eased by the signing of a ‘phase one’ trade deal last week between China and the US.

Of course, we require further evidence before we can categorically infer that economic activity is on the rebound. But that’s sort of the point – what is the need for the MPC to jump the gun on 30 January?

It’s also worth taking a look at the markets most affected by base rates – namely, borrowing and banking products. On the borrowing front, personal loans remain incredibly competitive, while the price war within the market for mortgages continues to intensify. Conversely, savings rates have fallen appreciably in recent months, and even reward offers and incentives on current accounts are dwindling.

This is because high-street banks have access to plenty of cheap money from the Bank of England at present, and are heavily incentivised to lend it out, rather than hold reserves. It thus explains why these lenders are able to offer low rates on loans and mortgages, but have little need to attract retail money from consumers.

This raises some important questions. How much lower do borrowing costs need to go? Will cutting rates further even have a proportionally positive impact on economic activity, given this low base? And is it really beneficial for society as a whole to inflict further misery on long-suffering savers?

Now is the time to hold fire

The above questions go to the heart of the issue. Interest rates were cut to emergency levels following the financial crisis, and remain in the doldrums today. There simply isn’t much ‘puff’ left. In fact, on the Continent, where negative rates have recently come into effect, there is little evidence of any incremental benefit to Eurozone economies – not to mention the inherent risks that come with entering such uncharted territory. Surely this is not the template we should be following?

Attentions should instead turn to fiscal policy to pick up some of the slack. That shouldn’t be a licence to loosen the purse strings irresponsibly, given the UK’s disconcerting national debt. But targeted spending on infrastructure, investment in capital projects and tactical tax cuts – as promised by the Chancellor in the upcoming March budget – are likely to provide a far bigger boost to consumers and businesses than anything the Old Lady could offer. 

We understand that the scars of 2007/08, when the MPC failed to get ahead of the curve before the big one, are still fresh. And of course, the very nature of central bank independence means that Mark Carney and Co cannot bank on fiscal co-operation from 11 Downing Street. But Carney, who departs his post in March, already leaves behind a legacy of missed opportunities; primarily his failure to normalise rates when economic conditions were benign in the middle of the last decade.

May his parting shot therefore not be a premature cut to rates. It must be pointed out that we as Lending Works have absolutely no skin in the game, as neither our lender rates nor our profit margins are linked to the decisions taken on Threadneedle Street. So, with only the UK’s economic health and balance in mind, we urge the nine-strong MPC panel to keep their powder dry when they come to vote on Thursday.