MPC must make bold cut in the cost of borrowing

At times like this, it is best to be frank. Nobody really knows where either the financial sector or the global/UK economy are headed. Rather than attempting some glib forecast, let me try to pick the bones out of the interwoven elements of the overall sorry story.

First, what immediate efforts have been made to ease the credit crunch and financial sector debacle? Second, given the inter-action between the credit crunch and the overall economy, what should the Bank of England be doing this week and thereafter so far as interest rates are concerned?

As the folk at Fathom Consulting have pointed out, we have seen a hierarchy of possible "solutions" to the financial crisis. The first step - used by the Royal Bank of Scotland and attempted by HBOS - was to seek further capital from shareholders, eg via rights issues, to shore up balance sheets.

The next option was to look at mergers as a way forward - Lloyds TSB/HBOS the classic in the UK, with other US examples. Where necessary the public sector becomes involved directly or to oil the wheels of this process - by providing a retrospective fit/fudge on competition legislation or whatever.

The "guaranteeing" of bank deposits fits in here somewhere. If all else fails, then massive sums of public money are required to re-capitalise and buy out dodgy debt.

We do not know if even the extreme examples will work this time around, given the severity of the trauma that has hit the sector. A period of stabilisation would be great and might see a most welcome, albeit mild, recovery of confidence.

Now let me turn to the somewhat easier, but still complex, question of what to do on interest rates. The Bank of England Monetary Policy Committee always has to look at the balance between the outlook for growth and that for inflation.

To be frank, I am amazed that concerns about inflation can be seen by anyone as dominant at this juncture; despite acknowledging that inflation could go above 5% very soon - far above target.

The appalling recent economic data and survey evidence show clearly that the dominant risks are with respect to growth. Recession is nigh or here while inflation is peaking. Given the clear expectation of zero or negative growth in the UK in the second half of 2008 and into 2009, coupled with the decline in commodity prices as the world economy slows sharply and the disabling effects of the credit crunch on business and household activity (not to mention confidence), inflation looks set to fall back towards target in the months ahead.

The task of the MPC is to focus on the outlook, not the present. If the prognosis is recession plus inflation returning to target, then the answer has to be a cut in rates.

MPC members should seriously debate a 50-basis point (half-per- cent) cut this week. Probably the best we can hope for is a 25-basis point cut now and then the same in November - with more later if needs be.

The impact will take time to work through, but the signal matters now. If the economy recovers rapidly and inflation stays above target next year, then we can all celebrate and rates can be put back up.

Please note that I am not suggesting that the MPC cut rates because of the credit crunch and as a change from their normal process; rather that the economic and inflation outlook, taking due account of the likely impact of that crunch on activity and confidence, justifies the cuts suggested.

Looking longer term, it is evident that we cannot just sit back - once stability has returned - and leave oversight of the financial sector as it was.

Change will be necessary, domestically and internationally. On the international front we have to recognise the interwoven nature of the sector, and the amazingly rapid way in which problems in one location and one sector spread globally and throughout all elements of the sector. Something akin to a new Bretton Woods conference will be required. This will have to include governments and central banks; representatives of the new economies as well as the old stagers. The IMF must have a major role to play. In advance of the outcome of any such conference - and this should be as action-orientated as possible - the watchword will have to be caution, in all significant economies, by all regulators and within all responsible financial institutions.

Domestically the tripartite relationship between Bank of England, Treasury and Financial Services Authority has not worked well. Many commentators see the need to return more authority on oversight of banks to the Bank.

Confidence in the present arrangements is shot, and must be restored as a matter of urgency. Chancellor Alistair Darling, FSA chairman Adair Turner and Bank Governor Mervyn King must not be so preoccupied with fighting the present and intense fire to ignore this issue of future management of the sector.