Stephen King: Why interest rates could plunge as low as 3.5 per cent

Since then, as far as interest rates are concerned, the Bank has been on its own. The Bank's independence isn't quite that of the European Central Bank - the Monetary Policy Committee (MPC) receives its inflation targeting mandate from the Chancellor, whereas the ECB makes up its own mandate - but, nevertheless, it's difficult these days to suggest that UK interest rate decisions are, in any way, politicised.

Since being granted its independence, the Bank of England has built up an eight-year track record of independent thought and actions, culminating in last week's interest rate cut. Membership of the MPC has changed over the years but, as with any formidable independent institution, it's difficult to spot any wild inconsistencies in the direction of policy associated with the changing faces of the MPC.

The economy itself is, of course, slowly evolving and the challenges facing the Bank of England evolve alongside these underlying changes but, on the whole, the Bank likes to set its policies in a "transparent" fashion: those who doubted that the Bank would cut interest rates last week were either questioning its desire for transparency or, alternatively, being deliberately obtuse. After all, Mervyn King's overriding ambition as the Governor of the Bank of England is to be professionally boring: it would have been just too exciting for words had the Bank of England decided last week to leave interest rates unchanged.

If there's one thing we've learned over the last eight years, it is that the cost of borrowing has fluctuated a lot more widely than the rate of inflation. For the most part, the Bank of England has had a tendency to undershoot, rather than overshoot, its mandated inflation target but inflation, as a whole, has been reasonably stable. Base rates, though, haven't been. Following independence, they rose swiftly to 7.5 per cent by the middle of 1998. A year later, they had dropped back down to 5.0 per cent, before rising back up to 6.0 per cent by the beginning of 2000. By the middle of 2003, they'd dropped to a low of 3.5 per cent, thereafter rising back up to 4.75 per cent last summer.

If inflation has been so well behaved, why have interest rates had to move around so much? The obvious response is that, had interest rates been held steady, inflation itself would have been a lot more volatile. I find this answer, though, rather unsatisfactory. Inflation the world over has been relatively steady in recent years, yet only some countries have seen fit to change interest rates relatively frequently. Unless the governor of a central bank has a manic desire to turn on the printing presses - an unlikely occurrence given the generally conservative demeanour of central bank governors these days - I suspect it's really rather difficult to create conditions whereby inflation suddenly shoots off into the stratosphere. Greater capital mobility, new technologies, more open trade, and intense competition both in product and labour markets have made a central banker's job just that little bit easier.

The reasons for the degree of interest rate volatility are, I think, a little more subtle. The growing credibility of the Bank of England plays an important role. In the early days of full independence, the Bank was, perhaps, a little unsure of its place in society. And society may have been doubtful about whether the Bank was able to do a good job. As a result, peaks in interest rates in the early years of independence were a lot higher than they are required to be today.

The Bank trusts society to behave itself a bit better now, and society trusts the Bank of England to get things right. As a result, the Bank was able to get away with allowing base rates to peak last year at just 4.75 per cent, a remarkably low level compared with previous interest rate cycles and a sure sign that, today, small changes in interest rates can, on occasion, have quite big effects.

The other important factor behind the more recent ups and downs of the interest rate cycle is that the Bank, despite its occasional claims to the contrary, has only aimed at the inflation target in a relatively loose fashion. Although the quarterly Inflation Report gives the impression that the Bank aims to hit its inflation target on a two-year horizon, the truth is that its approach is somewhat more "expansive" than that - and with good reason. Inflation targets should be regarded as medium-term ambitions, not the precise targets that you might associate with a game of archery. In many ways, what's more important is to control people's expectations of inflation, not the inflation rate itself. And that's what the Bank of England has succeeded in doing: inflation expectations, whether measured through asset prices or through surveys of the general public, have been admirably restrained in recent years.

But to ensure that these expectations remain restrained, the Bank really has to operate with a broader remit. It has to make sure, for example, that large movements in house prices, big changes in consumer debt levels and sizeable swings in consumer spending do not lead to cumulative output shocks that, in turn, could diminish the public's confidence in the central bank's ongoing ability to achieve price stability.

It is this broader remit that is likely to determine how far base rates will have to come down over the next couple of years. Although there will be short-term worries that the latest cut could reignite the housing bubble, the evidence in recent years suggests that base rates only start to come down when they can fall sustainably. On the two previous occasions when the Bank has chosen to lower rates from a previous peak, they've come down quite a long way.

The case for rate cuts is, if anything, likely to strengthen over the months ahead. Although the housing market has softened, valuations still look very high. Consumers, having got used to a world where rising house prices made them feel richer - and, therefore, happier to borrow - may have to get used to a world where they'll have to think about saving out of income. That can only mean weaker consumer spending over the months ahead. But rate cuts will, this time around, have to achieve something a little different. The Bank will not want to reignite a consumer boom. Instead, the MPC will be hoping to avert a consumer collapse and, at the same time, introduce a bit more balanced growth, with a little help from softer sterling and, hence, from stronger exports and, if companies could ever be persuaded to, a bit more investment.

How far could rates fall? The MPC's two previous rate-cutting periods saw total declines of 2.25 and 2.5 percentage points. If the MPC delivers the same treatment over the next two years, rates could drop below 3 per cent. Is this realistic? At this stage, it's too early to tell. But with the consumer reeling, with the Chancellor unable to provide much in the way of fiscal support, and with UK short rates still high compared with our main competitors - suggesting that there are still credibility gains to be had - certainly base rates should be able to fall to 3.5 per cent by the end of 2006.

Stephen King is managing director of economics at HSBC

stephenking@hsbcib.com