MPC would have risked a recession without cut, says Ernst & Young


Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club, comments on last week's interest rate decision.

Peter Spencer, chief economic advisor to the Ernst & Young ITEM Club , comments on last Thursday's interest rate decision:

"The MPC’s decision to cut base rates comes as little surprise to us. The credit crunch - which seemed to be resolving itself in October - has recently taken a nasty turn for the worse. One month money market rates have moved up to a premium of 100 basis over base rate. A base rate cut was necessary to prevent market rates moving up to even higher levels as the year end approached.

"These money market rates reflect the pressure on bank regulatory capital posed by the combined effect of loan losses and the need to take SIVs and other off-balance sheet vehicles back on board. As long as these pressures remain, banks will restrict the flow of credit to other sectors and make it more expensive.

"It is hard to estimate the effect this will have on the economy, since there is no recent precedent. The closest is perhaps the Savings and Loan crisis that hit the US banking system in the early 1990s – when it took two years of low interest rates to recapitalise the banks. However, many companies borrow at LIBOR and other rates that move automatically with IB rates, so their interest charges have already gone up. Average corporate borrowing rates are already two percent up on the year. The last time we saw this kind of increase (in late 2004) business investment growth fell back from 9% to below zero within six months.

"The UK economy went into this crisis with a strong momentum, but is now decelerating sharply. Although manufacturing seems to be holding up well, service sector confidence surveys have fallen back sharply. Advance indicators of the housing market also point to an abrupt slowdown. Cost increases remain a worry, but companies will find it hard to pass these on next year. If effective interest rates had remained at these artificially high levels for much longer, the MPC would have risked a recession in the economy next year."


If you would like to speak to Peter Spencer or Adrian Cooper, economic advisers to the Ernst & Young ITEM Club please call Rosanna Lander on 0121 535 2398/ 07952 351 018.


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