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The Bank's worst decision

Evan Davis | Vital Statistics |
5 Jun 07, 11:19 AM

Mervyn King, the Bank of England governor never comments on the past decisions of the .

He's often invited to admit to a mistake, or a regret, or even allow a moment of self-congratulation. But he generally declines to comment, explaining that the Bank has to focus on the next decision, not the last one.

He's right to remain silent. If he comments on one decision, he'll be invited to comment on another, and he'll soon be forced to comment on everything, which would be fine except his extensive commentary would then inevitably be over-interpreted.

But just because he doesn't comment, doesn't mean we can't.

And there is one decision taken by the MPC that deserves to be named and if not shamed, at least named and regretted.

It was taken in August 2005, and it was one Mervyn King himself did not agree with. Indeed, it was noteworthy as the first decision in the history of the independent Bank of England in which the governor had been overruled, and it was in retrospect probably also the worst decision the Bank has taken.

It was 4 August 2005, not long after the 7 and 21 July attacks on London. The Bank cut rates by a quarter point, from 4.75 to 4.5%, after a year of having held them constant, and prior to that having raised them from a low of 3.5%.

The upward swing in rates of the previous two years had actually taken the steam out of the economy and the housing market, and it had done so rather gently and rather successfully. I had personally described it as a "perfect slowdown".

So why cut rates in August 2005?

Well, the city expected a cut, and indeed another one to follow. Inflation was bang on target, the economy had slowed down to a 0.4% quarterly growth rate in the latest data, and there was a little concern that consumer spending would slow a bit too much.

Interestingly, the people on the committee who voted to cut were the professional economists. Charlie Bean, the late David Walton, Kate Barker and Stephen Nickell, plus Richard Lambert. They are all competent and sensible people, worthy members of the MPC; they acted on their interpretation of the data, and were clearly fulfilling the expectations of other economists too (the Reuters poll of analysts showed a large majority expecting a cut).

But in hindsight, they got it wrong.

The signal provided by that cut in August 2005 sent people back out into the shops and estate agents, and made them far too relaxed about the natural limits of the economic cycle.

It made them think 4.75 was the highest rates needed to go. And in unwittingly sending that message, the lower rate enticed people to borrow amounts that now seem incautious. In stirring up the economy. it sewed the seeds of what we now face -- impending rates of 5.75%.

Cutting the base rate was an easy mistake to make. Hindsight was not available to those supporting the move, and it was nine months before there was a single vote to reverse it (it was David Walton who led the way in May 2006, a month before he died).

But it seems to me there are four lessons from the episode that any new member of the MPC might choose to draw.

1. The committee should not attempt to fine tune the economy. Trying to be too precise in steering a course for the economy in response to quarterly growth rates is a mistake. And it is even more of one if the goal is to get rates as low as possible as quickly as possible consistent with the inflation target.

2. The committee should not be a hostage to city expectations of rates. Unless there is a danger of serious financial turmoil, the fact the City thinks rates will be cut is of no relevance to the decision whether to cut them.

3. For good or ill, interest rate moves have some signalling value. But it is the public who are the important signalees - not the city.

4. It is worth looking more closely at the evidence that does not fit the theory you have of the economy, than at the evidence which does fit the theory. In the August 2005 case, money supply was providing the oddball data. (One monetarist hawk, Gordon Pepper, who sits on the Shadow MPC of the Institute of Economic Affairs actually supported a quarter point rise in rates at the time). Money's importance was too lightly dismissed by the MPC. For me, this is not an argument for monetarism, as an argument for looking at all the data more open-mindedly. We are all subject to the strong tendency to frame a view of the economy, and then to select the evidence we define as important, and unsurprisingly to then find it supportive of the view we first thought of.

The minutes of the discussion at that fateful meeting suggest several members of the committee had reservations about the decision, and thought the City was far too inclined to think rates were about to enter a new downward cycle, and thought it was worth waiting more than usual, to obtain more information.

Looking at the consequence of the decision, one can say that it had a benefit - in probably mildly contributing to the 2.8% growth rate we enjoyed in 2006.

But the cost has been a degree of overheating that we are now dealing with, and a degree of over-borrowing. Much of that borrowing was on two-year fixed interest rates, and so the consequences of August 2005 will only come home to roost later this year.

PS Given I'm arguing with hindsight, I think it is only right to re-publish my words on the subject at the time, which were a bit equivocal (as they would be from a 91훑괵 journalist). But among my comments on the Ten O'Clock News were these:

"Looking back over the last few years, you could say consumers had a bit of a party and the Bank of England tried to damp it down. They brought out the strong black coffees to sober us up a bit. Cutting the rate again, it's like discovering a couple of unopened bottles of wine in the fridge and saying we can carry on. "

Comments Post your comment

1.
At 03:42 PM on 05 Jun 2007,
Paul wrote:

I agree with most of what you say. However, I think you overplay the effect of just a single 0.25% decrease in rates. My own perception (FWIW) is that real interest rates have been too low for a couple of years. The MPC has been mesmerised by the low CPI caused (amongst other things) by the deflationary China factor. They have ignored the warning lights flashing on house prices. Money supply has mushroomed, and the MPC now seems to find itself well behind the rate rising curve.

2.
At 08:15 PM on 05 Jun 2007,
Deepak Chawla wrote:

Economics (managing economy) is not only a science of data interpretation but also an art. The Art managing policies and livelihood of common people. This where I think the MPC has failed badly.

The difference between the have and the have nots have increased. The whole country has made more money just of valuation profits. ie Housing boom. Its just mini Enron's all over the country. Re-mortgaging the house based on valuation profit and then spending it.

Not to forget the difficulty for the new generation to start a life. Can you see the social implications: people not marrying, not having children. This will lead to problems in 30 - 40 years when a small number of youngster will have to foot higher and higher bills for the older.

The MPC might have succeeded in the science of economy but I give them an F grade for the art of managing the economy.

3.
At 09:08 PM on 05 Jun 2007,
Christopher wrote:

I agree that the cutting of rates two years ago sent the wrong signals and supplied the boom with a bigger puff than just a quarter point rise would suggest, thus they have egg on their face now?

I believe that they also made a mistake in the wake of the World Trade Centre bombings late 2001. The economy was already showing signs of overheating, which the bombings would have snuffed out if left, but the rates were cut too far too fast. This not only prevented a backing out of the boomb, but provided extra impetus and the debt bubble blew up to extreme proportions.

Will we in two years be saying that they made a mistake in not raising rates by half a point in May 07? we will have to see. In truth I think that there is little that can be done now to avoid the fall out of the bursting of the western debt bubble, which has already started.

4.
At 09:57 PM on 05 Jun 2007,
wrote:

I think once again we are missing the point. Economists shouldn't be spending their time debating interest rate rises and falls, they should be looking at what the causes of inflation are...fractional reserve banking and the abolishment of the gold standard.
and then once realising this point, campaigning for a gold backed currency and for full-reserve banking. It may be a perilous business standing upto the all-powerful lenders (look at the US presidents who tried it) but unless we do so, this loan-money created global economy is going to go through the boom-bust cycle constantly.

5.
At 06:54 AM on 06 Jun 2007,
Paul wrote:

I agree completely with your analysis. The problem appears to be that the MPC seems has no sense of urgency when house prices are going up at double-digit rates, but then panics as soon as prices slow or even fall a little. I personally did not agree with the rate reduction when it was made in 2005, for exactly the reasons you state - it sent a message to those that were over-extending themselves that the MPC would not allow house prices to fall.

The only way to quell the irrational exuberance is for the MPC to make absolutely clear that property is not a one way bet and can go down as well as up, and that if it does fall, the MPC may not be able to reduce rates to prop the market up again. Much of the buying, even at the present ridiculous prices, is driven by naive investors who believe it can go only one way, and helped by plenty of economists who insist that in the absense of a recession, mass unemployment or interest rates of 15%, there cannot be a crash.

To expose such a view as a fallacy, one need only look across the pond to the USA, where historically low rates and low unemployment is doing nothing to avert a collapse in house prices that looks like it could last years. And where the US economy goes, the UK is normally not more than a year or two behind...

6.
At 08:20 AM on 06 Jun 2007,
Juan C wrote:

I agree with your comments, but I think it will get worse before it gets better. The property market in my area (Surrey) is going utterly berserk, with propoerties selling in 1 (one) day for silly money and gazumping rife. And all this with relatively 'high' interest rates. Whilst I bought my house in Dec 2005 It will soon be time for the end of the 'two years' of fixed low interest. I think many people are going to be stung this time round. In my personal situation I can confortably afford the payments because I have no debts other than the mortgage, but in this day and age I am a rare case rather than the norm.
Although I should be 'happy' that property prices are going up, what happens is that I am worried this will end in tears...

7.
At 09:34 AM on 06 Jun 2007,
Tim Young wrote:

One problem is that there is an institutional and cultural bias in favour of lower interest rates, particularly in the UK (and US). The temporary stimulating effect of low interest rates on economic activity is well known, and remains a temptation to politicians and even central bankers with a desire to be popular and limited terms in office. In addition, however, as the UK runs a current account deficit, presumably there is an increasing majority of borrowers among its citizens. And they shout louder than the UK savers in interest-bearing investments, who tend to be older or less influential.

It should not be forgotten that, despite the accelerator/brake analogies used by journalist economists, interest rates are a price �� the price of loanable funds �� and a bias of departures from the market clearing level in one direction is liable to generate distortions. Yet, to see what I mean about bias, consider how the government proclaim low interest rates as an achievement, or imagine the likely media reaction to a statement like �쐇nflation is on target, so there is no need to lower interest rates��.

At the moment, in its surveys of the state of the economy, the BoE seems to talk largely to users of funds in businesses, or intermediaries such as investment banks. They should endeavour to also hear from lenders, such as savers�� groups, pensioners, personal wealth managers etc. Besides representing a more balanced range of opinion about interest rates, this might also help the BoE make more of the money supply figures, by providing more detailed information about the purpose of the deposits within the broader monetary aggregates.

8.
At 11:03 AM on 06 Jun 2007,
Ralph Corderoy wrote:

Evan, when you say "the people on the committee who voted to cut were the professional economists" do you mean they were the four appointed by Gordon Brown? In other words, of the five Bank of England members, only one, Richard Lambert, voted for the cut?

How is the MPC considered independent if, as the BoE's web site says, those four are "four external members appointed directly by the Chancellor". Surely, control-freak Gordon's going to put economists in who are "in tune" with the Governments wishes.

It's about time the media stop putting the word "independent" in front of "Monetary Policy Committee".

9.
At 12:19 PM on 06 Jun 2007,
Brian wrote:

Yes, the rate cut did at the time look very ill advised given the "out of kilter" nature of the housing market and the much discussed weight of debt.
But in the scale of things it is a minor slip compared with the persistent folly of a government that has allowed housing to become an "asset class" at the mercy of speculators, rather than treating it as an essential part of the social and economic fabric of the nation - a very special case.
On virtually any measure, other than affordability based on two earnings and historically low rates of interest (which now appear to be over at least in the medium term), housing is significantly over priced - say 30% if not more.
Why? And why have we allowed this to happen at a time when current low levels of inflation will not allow an orderly re-alignment of prices.
The social, demographic and long-term structural economic implications of this are extremely worrying.
But what is more worrying is the inability of the government firstly to understand this, secondly to accept that the scale of the problem and thirdly to shape policies that meaningfully address the issues.
Ultimately the state controls the supply, it should therefore address issues of demand - unless we accept that homes are tradeable goods and citizens do not have at least some rights to decent housing.

10.
At 02:54 PM on 06 Jun 2007,
Andrew Lilico wrote:

The August 2005 decision was indeed a mistake, and a number of us said so at the time. It was also a mistake that, with the benefit of hindsight, appears to have had potentially significant ramifications.

But it is an interesting question quite how *much* of a mistake it was, in the following sense: if interest rates had not fallen in August 2005, would we have expected them to fall in September, October or November 2005?

On the tale told here, the August change led people to go back to consuming and building up debt. But would they have done that, anyway, if the Bank had cut in November, say, or is the idea that the Bank should have waited until a slowdown was sufficiently well established that the moral hazard aspect of the interest rate cut (the sense that the Bank wouldn't let anything nasty happen, so we were safe to go on consuming) - this moral hazard would not have been an issue.

This, it seems to me, turns on the extent to which we believe that, when the economy is overheated, the MPC should try to act *early* - so as to "prick" any bubbles and then, on the downside, so as to limit any slowdown - versus acting *late* - i.e. waiting until bubbles have burst for themselves and waiting for a slowdown to have become established. The latter approach was that favoured by Greenspan - the "pick up the pieces" method. But in Britain we have often favoured the former approach - "taking the heat out of the housing market", and so on.

I suggest that one potentially important lesson of the August 2005 events is that the moral hazard problem is, for the UK at least, more significant than is sometimes suggested. Monetary policy needs to be humble in its aspirations - the key being (in these sorts of situation) that the MPC leaves itself enough room in interest rates to act - i.e. rates that are not too low if we might later need to cut, and not too high if we might later need to raise.

We need the tools to clean up and we need to time when to do it. To go back to your party analogy, it will be no good mopping the floor if the Party-goers have yet to smash a few more bottles...

11.
At 04:43 PM on 06 Jun 2007,
wrote:

Excellent stuff Evan, I think the key point to this is "expectations".

I suspect that this is what Mr King was getting at when last month he said it was important to "anchor expectations" - which is why my money (all 20p of it) is on a 0.5% rate rise tomorrow. While that might seem excessive in the short term I think the bank will consider it important for boosting its inflation fighting credentials in the future (in part weakened by that 0.25 cut in 2005).

I think that is why they talked about a half point rise last month - it was a signal of what to expect - oddly the City seems to be ignoring this signal - but after the ECB's quarter percent rise today and the Fed's hawkish comments yesterday don't be surprised if Mervyn shows a mean streak.

12.
At 05:10 PM on 06 Jun 2007,
Howard Wheeldon wrote:

All of the four recommended points made are emminently sensible but I particularly commend the view that the MPC should never be a hostage to city expectations. By the same token the city should, in normal circumstances, never be surprised as this disturbs the balance of normal market positions and trade. obtainable. This requires a change in the way the BoE communicates. Meanwhile, it is of course impossible to believe that MPC members can be expected to ignore the raft of comment and opinion around them either directly or distilled in press articles. But, as a thought, perhaps the MPC minutes should actually be kept private.

13.
At 06:40 PM on 08 Jun 2007,
Chris wrote:

Any decision which is a departure from the prevailing trend will be taken as a signal

14.
At 07:37 PM on 08 Jun 2007,
Lucy wrote:

I'm very impressed with your ability to see things clearly. What are your feelings for the London property market? And are property prices really going to be 10 times average earnings in the future!

15.
At 10:38 AM on 09 Jun 2007,
Steve wrote:

I think too much is being placed on a .25% decrease in rates. After all, it will take more than the increases so far to curb consumption. If that is the case, and it is, then looking back to interest rates then, to where they are now, simply reducing rates by .25% cannot have encouraged overspending. It had already started and would have (will) need aggressive application of rates by the economic architects to curb the appetite of those within their arena.

Keynes identified the wealth factor; if you feel "rich" you spend "rich". Less aggressive union demands, lower rates of pay for many underpaid workers, while others have seen job security with pay increases at, or above, inflation, contrives to produce a benign economic arena; so far! When interest rates bite, as they will, consumption will fall-Keynes again (reduction in the wealth factor)-as consumption falls demand drops and the circle of cut-backs, wage restraints-conflict as in the Post Office-mount, ergo, job losses; and the extent is always unclear in its midst.

The reality is that all governments since Keynes have identified consumer confidence as a clear indication of electoral success. This government has allowed, indeed encouraged, house price inflation as it has supported consumption through equity releases finding its way into shops, bigger mortgages and buy-to-lets. To slow consumption would (will) mean aggressive use of interest rates, not a vote winner.

The extent of decline is never known without hindsight. That is why economics can never be a science, it relies too much on human values, and political expediencies. However, what we do know is, it will always be the general public who, whether, �쐃yes wide open or not��, entered this arena, and will ultimately pay for its construction, while the architects continue largely untouched from the fall-out.

The bank may be �쐇ndependent��, but it is still part of the great and the good, who, throughout history, have evaded many of the consequences of economic slow-downs!

16.
At 12:29 PM on 11 Jun 2007,
Paul JW Callicott wrote:

The rate rises that started in 2006 have probably came 6-12 months too late. Interest rates should have been increased in 2005 and not reduced.

Looking at the money supply data and personal fiscal tightening due to tax rises, 2005 pointed to an overheating economy that needed to be gently cooled. The bank missed the boat akin to Nigel Lawson in 1988. Letting the economy continue to over heat during 2005/06 has now meant that we will have to suffer higher interest rates for a longer period to correct the economy and maintain low stable inflation.

Although I don't think the economy is as much out of equilibrium as 1989, I feel the high level of personal debt accompanied with a booming housing market and over the last 4 years a high level of income created by wealth serves many reminders to the late 1980's. I don't expect GDP to fall as sharply as 1990-1992 but unless the economy is effectively managed with good fiscal and monetary policy over the next 6 months. The good times could be coming to an end for many.

17.
At 05:08 PM on 12 Jun 2007,
James wrote:

In my humble opinion the greatest success of the MPC was to leave the rate unchanged for so long.
The stability this brought about allowed some breathing room for ordinary people who wished to be able to start planning their financial futures, but the reintroduction of a fluctuating rate decimated the public confidence in their own ability to plan for security as a great number of the plans made by average people were rendered redundant by the moving goalposts.
So we put our heads down again and prepare to renew the long, hard slog.
It is an old rule that volatility creates winners and losers, but it is also true to say that while the winners are always found in the city, the losers are found in every gutter across the country.
A centralised decision-making bureau will always be subject to pressure from the swings of opinion that occur when power is concentrated in so few hands - different groups will always seek favour at another's expense and wealth will remain widely percieved as simply relative until the flawed paradigm is rebuilt with a democratic heart.
The misconception is to equate influence with control just as it is to describe economic patterns as cycles.

18.
At 05:41 PM on 20 Jun 2007,
wrote:

I am no economist but keep a key eye on developments in the housing market because a) we cannot afford a house (!) and b) we suffered in the last crash in the 90s and it ruined us financially c) I agree with your contributor Deepak Chawla who wrote 'Not to forget the difficulty for the new generation to start a life. Can you see the social implications: people not marrying, not having children. This will lead to problems in 30 - 40 years when a small number of youngster will have to foot higher and higher bills for the older'
I agree that it is the social implications which the government seems reluctant to tackle - decent housing is essential for ordinary folk. Today we have elevated levels of childhood mental health problems etc Is it any wonder when the parents are so stressed and when families are squashed into tiny houses with little space? And they are too busy working to pay inflated house prices to have time for the children. Call this progress? It seems to me that we have regressed, not progressed. Surely the MPC should take the social implications of its decisions into account too - not just the economic ones?

19.
At 10:35 AM on 27 Jun 2007,
Dave H wrote:

Perhaps I should have a job at the Bank of England?

"low rates are driving the demand for credit" - well, who would have thought it?!

The BoE is not independent as most of the Board members owe their positions to the Chancellor (now PM!). Their biggest error - as I have said before - was to drop rates below 4%, the liquidity trap in UK (where it just fuels asset prices), but what do I know?

20.
At 12:32 PM on 13 Jul 2007,
Tommy wrote:

It is always very interesting reading these type of comments on interest rates and property prices etc. The people are obviously very clever, having a true grasp of macto-economics and human pyscholgy etc --- BUT !!! even though we believe we are all right intellectually, we have missed out on a fortune by not following the market !!!!

So, Intelligent but poor !!

Think I would prefer being Thick and rich !!!

21.
At 02:04 PM on 03 Aug 2007,
wrote:

Despite earning a respectable salary and having been in credit since 1993 as a single person I simply can't afford to buy any property in London that isn't either somewhere on the periphery of zone 6 or attmepting to compete for the title of 'London's most murdered on street'.

So interest rates can go up to 15% as far as I'm concerned. The thought of hundreds of thousands of people weeping their way through repossession proceedings while the banks that put them there in the first place refuse to take any responsibility for their actions moves me not one iota.

22.
At 01:50 PM on 31 Aug 2007,
Chris wrote:

If one understands franctional reserve banking and the people who control the central banks it's all to plane to see.
Money as debt and The Money masters.

23.
At 02:21 PM on 31 Aug 2007,
Anonymous wrote:

Bankers have no social responsibilities or loyalties.
My question is where does all this wealth come from. Gold reserves?

Enslavement through debt!

24.
At 03:41 PM on 26 Sep 2007,
Paul_Mafinga wrote:

Good article Evan. At the time I too thought that it was a surprise and a mistake, fuelling more double didgit house growth and consumer spending.

However, if you were on the MPC, surely you may have a (partial)defence to (y)our accusations. Their target is to keep CPI inflation at or around 2% over the medium term, and for CPI to remain within a band of 1% above or below the central target. The medium term is defined as 2 years. We are now 2 years on from that decision, and the August 2007 CPI figure is 1.8%. They could surely argue that their policy (including that cut) has been a success. Yes, they breached the range for the first time in 10 years, but it was only for 1 month (and anyway, once in 10 years itself is a good record).

I agree CPI is a usless indicator of the cost of living, as would most of the MPC. But their job is to target it, and I think they have done well.

25.
At 02:01 PM on 06 Nov 2007,
Roger Eccles wrote:

Re the bank bad loans crisis , what is going to happen at audit time ? A " true and fair view " must be taken of assets and liabilities . If there is insufficient information for a valuation , a qualified report must be issued . This would be unthinkable for massive institutions .

On a lighter note , I am reminded of a con trick operated in Oxford street a few years ago . The main man would gather a crowd and say that he was selling mystery parcels for 짙5 . His confederates would make the first offers and loudly announce that they had received a gold watch . After that it was easy to sell the other parcels which of course were duds .