Later today at noon, to be precise the Bank of England will announce its latest decision on interest rates. So what’s it going to do? The question is a lot harder to answer this month than we’ve been used to for the last few years.
Recent economic data on the UK has been nothing short of dreadful.

But, at the same time, inflation is above target and it’s likely that governor Mervyn King will have to get his biro out more than once this year as CPI overshoots the upper limit of 3%, forcing him to write a letter to the Treasury explaining why.

So it’s hard to say whether rates will stay put or fall. But more to the point, whatever the Bank does, will it make much difference to anything?

The economy is in even worse shape than feared

Until this week, the consensus was that the Bank of England would keep interest rates on hold this month, then probably cut them next month. Now markets aren’t so sure. The pound fell sharply against both the dollar and the euro yesterday, as economic data suggested the economy is in even worse shape than feared.

Manufacturing output fell 0.5% in March, the biggest decline in six months, rather undermining the notion that the UK can economy can be saved by that much-neglected sector. Meanwhile, Nationwide reported that consumer confidence is at its lowest since the building society began producing the survey in May 2004. That’s not a terribly long time to be fair, but do remember that summer 2004 was when the property market had its little blip which the bulls had hoped would be duplicated this time round.

More worrying was news earlier this week that service sector activity is slowing sharply. With the vast majority of the UK economy dependent on services, any slowdown or shrinkage will hit us hard. This of course, is inevitable. People don’t have as much money as they did, and with estate agents, City banks and builders already slashing jobs, it won’t be long before the impact of rising redundancies starts to be felt in earnest on the UK high street.

This is all bad news for the economy. But bear in mind, that unlike the Federal Reserve, the Bank of England specifically has to fight inflation. Right now inflation is above target (2.5% according to the consumer price index (CPI)). And although the Bank might suspect that a shrinking economy and falling house prices could put a lid on it, that’s not something it can rely on right now.

With oil prices hitting new records every day (Goldman Sachs now reckons we could see a ‘super-spike’ to $200 a barrel), and food prices doing the same, trying to argue that inflation’s not a problem just won’t wash. Given that the Bank’s job is so specific – to keep CPI at 2% – it’ll be hard for the Monetary Policy Committee to justify cutting rates without acknowledging that the economy is in a truly awful state.

But the bigger question is – what difference will a cut in rates make? Well, it won’t help house prices. Banks are now no longer interested in splashing money all over the housing market, so interest rates on new mortgages will keep rising or stay static pretty much regardless of what happens to the base rate. And in any case, with prices now clearly falling, any sensible buyer will stay firmly out of the market, regardless of what the banks are offering.

Hamish McRae in The Independent argues that “cuts in rates, however, are not intended to rescue house prices; they are to rescue the economy.” He acknowledges that there will be “quite a painful adjustment in household spending” as Roger Bootle has pointed out. “But then we have over the past decade experienced the fastest growth in overall demand of any of the major developed economies… the three or four slim years would follow a decade of fat ones.”

I’m not meaning to pick on Mr McRae specifically here, but his views sum up nicely the general feeling that still exists among mainstream economists. This is the idea that things won’t get that bad. After all, the housing market’s not the be all and end all of the UK economy, is it? And we have had a long period of growth – it had to slow down sometime, didn’t it?

It’s too late to save the economy from recession

The trouble is, this long period of growth was an illusion built on debt. Consumers have spent too much, and the government has spent too much. Both of those trends are now ending. Consumers no longer have access to cheap debt, and the government will have to tighten its belt too, particularly with so many big companies threatening to take their taxes elsewhere.

And cheaper money won’t help. That’s partly because the cheap money won’t make its way to consumers, but mainly because the massive bubble that’s now exploding, was caused by cheap money in the first place.

So cutting interest rates won’t stop the economy from heading down into recession. What it will do is weaken sterling. And that will make the impact of high commodity prices even worse as sterling weakens against the dollar. So, like it or not, a rate cut today would be inflationary, and probably should be avoided.

That doesn’t mean it will be of course. But I suspect that Mervyn King will be putting up quite a fight this month to keep rates on hold.

Source: Why an interest rate cut will only make things worse