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Looking forward to the 1932-33 Ashes series of test matches in Australia, the English cricketing selectors faced a daunting task – how to blunt the challenge of Don Bradman, the greatest batsman of his generation and, some would say, the greatest-ever Australian batsman. The English captain, Douglas Jardine, asked England's fastest bowler, Harold Larwood, to bowl consistently and aggressively at the Australian batsmen's leg side. This forced each batsman to defend himself against being hit by the ball. It made it very difficult to play the elegant strokes which a batsman like Bradman used to build winning scores. It was blatant gamesmanship, designed to counter the greater batting skills of the Australians. The Bank of England Monetary Policy Committee (MPC) appears to have a similar problem to England's cricketers of the 1930s. Its mission in life is to control inflation – to keep it around 2%, a target set by the Government. It is a miracle of the modern world that politicians have managed to relinquish control of interest rates and to allow the Bank to act more as a modern central bank. Even so, the MPC has a daunting task. To keep inflation within bounds using the single tactic of interest rates. Now, if you had just one tool to control inflation, you would probably choose interest rates. But, like any craftsman, you would probably prefer to use a range of tools, to suit the particular job in hand. It's also worth saying that interest rates are a very effective blunt instrument, but not terribly sporting. A hammer rather than a scalpel. There has been a decade of economic stability in the UK. There has been a sustained housing boom, low interest rates and low inflation, throughout. Economic growth has been satisfactory, if not spectacular, and unemployment has been at manageable proportions. The workforce has been increased and enhanced by skilled and committed migrants from around Europe. Cheap imports from China and other Asian economies have helped keep price inflation in check and offer a wide range of consumer goods at low prices. The world economy is richly complex with a huge range of factors pulling in many directions at the same time. The specific impact on the UK economy of any of these factors is difficult to fathom, and even more difficult to predict. At any monthly meeting of the MPC, there may be a dozen major issues to consider. When this is all weighed in the balance, the decision to be made is whether to leave interest rates at the same level or make a marginal shift upwards or downwards. By this single means, it is hoped to keep inflation at around 2% in the longer term. The issues facing the MPC are particularly difficult. Inflationary pressures are rising. Oil prices stand at more than $90 (£41) a barrel. Other energy supplies are less certain and prices are rising. UK and US house prices are falling. UK household debt is high and rising. The banking sector is sorely troubled by the credit squeeze and the impact of sub-prime lending in the US housing market. We have even had another rogue trader at work in the banking system. More worrying for the UK economy is the steady improvement in the US trade deficit. Exchange rates are particularly favourable to US exports and there are nearly two dollars to the pound. The Asian economies are better placed to absorb this change in the terms of trade. So the prospects look worse for the UK and the rest of Europe, where the price advantage over the US is led by the exchange rate, rather than by lower raw material costs and lower labour costs. If the US economy can ride out the credit squeeze and the slump in house prices, that would be a clear demonstration of its underlying strength. Even though most commentators are pessimistic about the prospects for growth in the US gross domestic product, there are fewer structural barriers to growth in the US than in Europe generally. The US mortgage crisis may well mean consumer demand is depressed because people feel worse off. The impact is likely to be a sustained reduction in demand for imported goods in the US, with a stronger impact on the UK and the rest of Europe than on Japan and the Pacific economies. The latest development in this arena is the dramatic fall in US interest rates. So, what will the MPC make of this latest challenge? How will it use interest rates to counter these threats? The obvious answer is to reduce interest rates to boost the economy in the short term. However, the market may have already factored a further rate cut into its pricing, and there are clear signs banks are increasingly being choosy about who they lend money to. There is evidence, too, that they are looking to charge more for their services. That sounds suspiciously like an increase in market interest rates. The MPC will reflect on this. its members have an excellent track record and an enviable knack of taking the right action in the right timeframe to the right extent. For an operation so dependant on a single mechanism, they have shown unerring capacity to use it well. Such single mechanisms may well provoke a tendency to ‘up the dosage'. There will be some who say that the MPC is in danger of losing control of monetary policy and needs to act decisively. That would imply further reductions in interest rates, even though it seems not to have worked, so far, in current market conditions. Eventually, low interest rates could fuel inflation, although the recent increases in mortgage costs are likely to take some heat out of the economy early in 2008. The MPC's track record is stronger than the MCC's was in the 1930s. It has options beyond having to resort to bodyline bowling. But the underlying strategy looks disconcertingly similar – a reliance on a single tactic in a complex scenario. One is left wondering what Plan B might be. Seventy-five years on from that fateful cricket tour of Australia, the bodyline bowling controversy still rages. It will be interesting to see what the lifespan of the discussion on controlling inflation will be. Jim Brooks is executive director of Sector

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FINANCE

Bowled over by interest rates

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