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Credit and credibility

• Robert Peston
• 6 Nov 08, 05:58 PM

The Bank of England has some explaining to do.

In September, it said there was a case for raising interest rates - that there was a risk inflation would remain above the 2% target.

Since then, the Bank of England has cut interest rates by two full percentage points, including today's cut of 1.5 per cent - a bigger cut by far than any it has made since it took full control of setting what's known as the official Bank Rate.

And in slashing that interest rate, it said there was now a serious risk of inflation undershooting its target - because the economy is shrinking so rapidly.

How on earth - you might ask - could economic conditions change quite so fast?

How could inflation be the worry in September and a deep dark recession be the fear today?

Is it possible that just two months ago the Bank of England failed to assess properly the weakness of the economy.

This really matters - because the Bank of England's success for a decade after 1997 in controlling inflation and providing a firm foundation for stable economic growth stemmed in part from its credibility.

It succeeded because the important economic players - businesses, employees and consumers - negotiated to set prices on the basis that the Bank's judgement about the outlook for inflation was probably right.

If the Bank's judgement were no longer trusted, its ability to do its job - to control inflation - would also be seriously impaired.

UPDATE 20:30: The IMF has tonight published a forecast that the British economy will shrink by 1.3% in 2009. That's a full 1.2 percentage points worse than the prognostication made only a few weeks ago by the ambulance service for the global economy.

That deterioration in our economic prospects helps to explain why the Bank of England has acted so decisively today.

But the IMF is also predicting that the performance of the UK will be the worst of the developed economies - which puts more pressure on the Bank of England to explain why it was inappropriate to make such a cut in interest rates rather earlier in the autumn.

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Who benefits from rate cut?

• Robert Peston
• 6 Nov 08, 01:22 PM

I've just had a call from an astonished individual who has several hundred million pounds that he puts on deposit in various banks.

As of 10 minutes ago, a leading British bank was offering to pay him almost 7% interest for his cash.

That was after the by 1.5 percentage points to 3% - an unprecedented reduction in the history of the Bank's Monetary Policy Committee.

Why does it matter that this holder of squillions is still being offered almost 7%?

Well, if he's being paid almost 7%, what chance is there that small businesses will be able to borrow at less than 10, 12, 14% or more (with the actual rate depending on an assessment of their credit-worthiness)?

Those who most need a substantial cut in the interest they pay - hard-pressed businesses, cash-strapped households - are unlikely to enjoy more than a small reduction.

As I described in my note on Sunday ("Why interest rates are not falling") the transmission mechanism from the Bank of England's policy rate to the interest rates we pay has broken down.

Lenders have - understandably - concluded that the risk of lending has risen very sharply, and are therefore demanding much greater rewards for providing credit.

So at a time when all the indications are that we are in a fairly severe recession, and many companies and individuals are struggling to keep afloat, it's a serious worry that even the kind of evasive action attempted today by the Bank of England may provide only modest succour.

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