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Splitting the difference

• Evan Davis | Notes on Real Life |
• 7 Feb 08, 03:29 PM

Today's decision was unusual in that it could have gone three ways - it could have conceivably been a half point cut or no cut at all.
The reason there's such a wide span of options is that the economy is sitting at a crossroads. It could take one of three routes from here, but we don't know which one it will be. Unfortunately, we know those three routes take us to three very different destinations with very different implications for interest rates.

One route is towards an unpleasant recession -- the kind of early 90s experience.. or even worse, the Japanese 1990s experience.

With the housing market falling and the banks suffering, you might reasonably worry about such a scenario. And if you do, you would probably think a half point cut is needed. i.e. the sort of central bank action that you get in the US.

But while the US appears to be on course for some kind of recession, the situation is far from clear-cut in the UK. We still face a second possible road that takes us towards inflation.

With the pound falling and global commodity prices rising, we might actually need some kind of significant slowdown just to kill off the pressure for prices to rise. If we knew we were heading in that direction, it would have certainly justified holding rates as they were.

In the event, the Bank opted to split the difference on rates, evidently hoping the economy will take the third road -- towards a rebalancing of the economy.

This involves a relatively gentle slowdown with only a temporary upturn in inflation. The rebalancing part of the story sees the economy shift away from its dependence on consumer spending towards exports.

We can be sure that this third road is the one we want the economy to take. Unfortunately, we can't be sure it's the one the economy will take. Economists are divided over which direction we are moving in.

The statement -- released with the quarter point cut -- makes pretty clear that they recognise the economy is sitting at a crossroads, and all three routes are still possible.

Their job is simple: to navigate us towards the good rebalancing route, away from the bad inflation and ugly recession.

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