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Interest rates: a balancing act

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While inflation remains a very real problem for the UK, higher interest rates, coupled with stagnant growth in the UK, could result in our current downturn developing into something more akin to recession. A technical recession – two quarters of negative growth – is still a distinct possibility, and it doesn’t take Adam Smith to realise that further rate rises might tip our economy over the edge.  

But lowering the base rate too quickly could do just as much harm, allowing inflation to run riot. Inflation is a sinister beast that if let loose, devours savings, tramples consumer purchasing power and plays havoc with the country’s business confidence.

The government uses the Consumer Price Index to measure inflation and it is against this that it targets the Bank of England. In August, the CPI was 4.7 per cent but if we extract fuel and food costs, inflation drops to nearer 1.6 per cent.

Interest rates are the MPC’s sole weapon to tackle inflation but they can take up to two years to have an effect. When food and fuel prices stabilise (which most forecasters believe will happen within 12 months, albeit at a distinctly higher level), it is likely that inflation will fall as quickly as it has risen, after reaching a peak of 5 per cent. Once it starts falling, the central bank will likely lower rates to deal with the slowdown. I expect this will happen towards the end of the year.

Cutting rates now will ease borrowing for businesses and consumers but it could stoke inflation in other areas. This could then adversely affect wage settlements, the current restraint of which at the time of writing is helping to contain inflation below the 5 per cent mark.

This is why I’m convinced that the MPC has been right to hold interest rates as long as it has, and why I think it should continue to do so until November. Pre-1997, and especially during the 1960s and 1970s, the typical course of action in the present circumstances would have been for politicians to make knee-jerk and populist decisions. In the past, however, this often caused long-term damage to a fragile economy.

Given the inflationary challenges of previous decades, things aren’t as bad as they seem. We need to guard against short-term memories clouding our thinking and consider the present situation as a sharp, one-off rap over the knuckles for the excesses of the last few years out of which the economy and well-run businesses will emerge all the stronger.

Lehman Brothers’ recent collapse – and Merrill Lynch’s impending buyout – has thrown something of a spanner in the works and will certainly result in the MPC cutting rates at some time in the future. But I don’t expect this to happen in October. I think the MPC will wait a little longer to see how the markets react to this latest crisis.

However, the committee may not wait, as many economists have predicted, until the New Year now that the entire investment banking sector is in turmoil. These are challenging times for the economy and we are still a long way short of recovery.

*Steve Mason is the finance director of Siemens Financial Services and a Real FD columnist.Related articlesTips to cure the credit crunch hangoverThe FD must take a lead on information securityA strategic view in the credit crunch is crucial

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