In football terms it was akin to Manchester United’s 1999 European Cup victory over Bayern Munich with two goals in stoppage time. Reception to the news was equally euphoric. Retailers hailed as it “welcome but overdue”, while a City analyst said the bank had “played Santa”. Right up until the Monetary Policy Committee began its two-day meeting, businesses and economists were pretty sure rates would stay at 5.75 per cent. Economic data was mixed and some members of the MPC were worried about inflation. Domestic demand rose by a robust 1.2 per cent in the third quarter. Rachel Lomax talked of the “risk” of signalling rate cuts when energy prices were rising. Tim Besley was worried about inflationary expectations becoming embedded. But, on the first day of the meeting, came two surprises. Growth in the services sector fell to a four-year low, while house prices suffered their third successive monthly fall. The mood in the financial markets and media turned instantly. Sterling futures priced in a rate-cut and headlines screamed for the bank to take action. While many businesses will find it hard to fault the decision, the bank’s behaviour has left some nagging worries going into 2008. The first is a perception it caved into pressure from the markets and media. The danger is the bank then gets locked into following the market. Two more rate cuts to 5.0 per cent are already priced in. But if house prices fall further, will the bank deliver steeper cuts even if inflation is still rising? This leads into the second issue – housing. The last time the bank was in this position was summer 2005 when house prices fell. The bank surprised with a rate cut and, in retrospect, fired the starting gun for another surge in prices, creating a feeling it would always bail homeowners out. This time the fall is steeper, 2.3 per cent over three months, but that follows a trebling of prices over the previous ten years, a period in which the bank thought it was wrong to target asset prices. Third, there is a feeling the bank has had to extract itself from a mess of its own making for the second time. Earlier in the year it held firm to its line that the central bank should not bail out one financial institution whose own errors had brought it to the brink of collapse. Then it intervened to save Northern Rock. This time the bank, or least several of its senior figures, banged the inflation drum hard. Then when it cut rates it cited signs that growth was about to slow. This leads into the fourth point, that it is now less clear whether the bank is targeting inflation or growth. Inflation is rising while households’ expectations are for it to rise to 2.7 per cent, 0.7 per cent points above target. Slower growth will lower inflationary pressure but much of inflation comes from oil and food, which will not be affected by a change in the UK economy. Fifth, the bank may not be in control of monetary policy. Some analysts had cited the high level of Libor, the price banks pay to borrow from each other, as another reason to cut the official rates. Yet short sterling futures, which indicate where the market expects interbank borrowing rates to be in two weeks’ time, actually rose after the MPC’s decision. Finally, there is the nagging fear that the bank knows something the rest of us don’t, perhaps in the buy-to-let market that is so exposed to the credit crunch. So what do we know about 2008 that we did not know before? There is a good chance growth will be lower and inflation higher than previously thought. Interest rates could come down by far more that had been pencilled in – four per cent is a distinct possibility if the housing market proves unresponsive to initial cuts. The chance of steep rate cuts will undermine the pound. Sterling’s exchange rate against its main trading partners has fallen 3.4 per cent since 1 November. Expect further depreciation. Finally, the bank’s decisions will be harder to read. It is quite possible there will be more outcomes that appear, in sports commentators’ hackneyed phraseology, a goalmouth scramble in the dying moments of the game.
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