How significant is a cut in rates anyway?

In the wake of the Bank of England's recent quarter per cent cut in interest rates, just how will it effect the market? Dennis Turner finds out

It all seemed so predictable and justified. Predictable because the voting at the Bank of England’s Monetary Policy Committee (MPC) had moved steadily in favour of a cut, from 8-1 (in favour of no change) in April to 5-4 in July.

So when the committee met in August, it would have been more of a surprise if rates had not come down. The fall from 4.75 per cent to 4.5 per cent was the first change in base rate for 12 months and the first cut since July 2003. Now the rate cycle has turned, more cuts are expected and the HSBC forecast is for rates to drop below 4 per cent in 2006.

This is justified because of the mounting evidence of weakening economic activity. As inflation risks diminish, so the MPC’s attention turns to growth, and the pace seems to be slackening across the board.

Permanent sales on the high street testify to the fragile state of consumer spending while the CBI reminds us of the dire state of manufacturing. And the housing market seems at last to have responded to the tightening of policy that began in 2003, with both prices and new lending continuing to ease. So when the growth of the economy in the second quarter came in at 0.4 per cent, it was in line with what the other statistics were saying.

The year-on-year growth rate has declined to 1.7 per cent, the lowest in 12 years. This compares with the trend rate of around 2.5 per cent and the Chancellor’s budget forecast of 3 per cent-3.5per cent. For once, Gordon Brown looks well wide of the mark.

When the parlous condition of public sector finances, the ongoing weakness in the key export market of Europe, five consecutive monthly rises in unemployment numbers, and the growing evidence of debt pressures on a fragile consumer are factored in, it is clear that the economy needs a boost.

With the Chancellor forced to redefine his “golden rule” to make it appear as though he is being prudent with public sector finances, it is clear that monetary policy rather than fiscal policy mustprovide the stimulus for faster growth.

By cutting rates, the MPC hopes to do three things. The most obvious is to make it clear that the period of rising rates is over for now. Second, to make it cheaper for those with little debt (particularly companies) to borrow. And third, to reduce debt servicing costs for borrowers, thereby freeing up spending power and speeding up debt reduction.

It is doubtful whether a quarter per cent rate cut will achieve much. It will certainly signal that borrowing costs have stopped rising, but it may take further reductions to ease debt burdens significantly, and most observ-ers expect further cuts in the coming months.

And the boost to consumer confidence may be offset by the rise in unemployment. In any event, given the time it takes for the full effects of rate changes to work their way through, this will be a poor year for growth whatever else the MPC does between now and Christmas. And the rate cut may not be such a good idea in the medium and longer term.

Despite being predictable and justified, the policy easing might simply lead us down the same path of too much consumption and borrowing. GDP might pick up, but rate cutting alone is not the answer. Although supposedly the first step in reviving activity, this cut in rates leaves important issues about contributions to the UK’s economic growth unresolved.