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Bank of England pours oil on troubled waters

ECONOMY

The latest cut in interest rates is no bad thing but looming war overshadows the economy at large, writes Brian Green

THERE is something rather surreal about trying to predict the fortunes of the economy at the moment and, in particular, prospects for UK construction.

To get a handle on the economic future, economists must take into account the length and consequences of a war that has not yet even started.

To hear the phrase 'the best outcome from an economic point of view is a short, sharp war' is a touch unsettling, however true.

Unsurprisingly in such times, people who are filled with uncertainty turn to those they feel they can rely on. So, when the steady, reliable, solid Bank of England trimmed interest rates this month and surprised economists and City pundits alike, it spread concern.

The ensuing speculation generated unusual interest in the press conference which hosted the bank's somewhat sober quarterly inflation report on its 10th anniversary.

What did the rate cut signal?

Did Britain's top economic gurus see trouble ahead?

At the conference, Governorelect Mervyn King - speculated to have favoured holding the rate but voted out of protocol rather than conviction for a cut - poured all the oil necessary to calm troubled waters, reaffirming his ambition to be 'as boring as possible'.

He said the monetary policy committee had been aware that the rate cut might lead to speculation that it shared some of the 'doom and gloom' of some recent commentary. Yet, he insisted, the central projection remains one of growth close to trend and inflation close to target - although inflation is projected to rise above the target for part of the next two years.

Whatever the internal politics, it is hard not to see the move to cut interest rates this month as indicative of the smart thinking and clever management of expectations that has characterised the bank's moves and speeches since it took the interest rate reins.

For all the balance of arguments for and against a cut, ultimately the issue for economic management is one of timing.

And in the case of this cut, especially one so unexpected, the timing seems to have sent out the right signals.

The UK economy has been dogged by the so-called twospeed economy - an industry under pressure while consumers are pretty rampant, fuelled in part by the wealth effect of rising house prices.

'Two-speed economy', Mr King told his audience, was not a phrase he used. Nonetheless he explained the Bank had a limited ability to address such imbalances in the economy - which he put down largely to exchange rates - having just the one economic instrument to use, interest rates, which the monetary policy committee uses to target inflation.

But the monetary policy committee appears to have used its one lever to great effect. A cut in interest rates should, in theory, fuel house price inflation.

That would be a bad thing right now, when the much-needed slowdown in 'unsustainable' house price growth is far from established.

The 'surprise' cut, however, comes as many people were uneasy about economic prospects and against a background of impending war with Iraq and apocalyptic forecasts for house prices.

In this environment the effect of a cut was paradoxically more likely to engender caution than exuberance, as many would interpret it as signalling worsening economic fortunes.

For many people about to plunge into buying a house or considering a move up the ladder, shaving a couple of pounds off their potential mortgage payments will hardly seem enough to compensate for increased fears over the economy.

The net effect should be more caution, which in turn should help check house price inflation.

For those with mortgages, a few pounds less to pay each month will also come in handy, with the rise in National Insurance on the way.

In the economic slow lane, manufacturers will see interest payments on debts cut, a small but welcomed bonus with impending National Insurance rises and any consequent lowering of the exchange rate of sterling will be all the better for the manufacturers.

So what does this all mean for construction? Well in the main it is good news, especially for materials producers servicing debt and fighting foreign firms.

Subcontractors should be better placed to finance the money they are owed. House builders will be able to shore up flagging sales. As for contractors, consultants and facilities managers, it really depends on how they manage their cash, but few will see it as a bad thing.

Ultimately, the prospects for UK construction rest more with the outcome of events in the Middle East than Threadneedle Street.

As the Bank of England's inflation report states: 'A war is also likely to have implications for UK expenditure. One direct effect of war is that it would add to the upside risks to public spending.'

There is, it points out, a £1 billion special reserve in 2002-03 to fight global terrorism but, if the costs were to escalate out of control, the pressure to cut other public spending would increase.

This would not be good for construction, which has not for many a year relied so heavily on public spending for its prosperity.

Pointers

The pointers tables give a snapshot view of the level of contract awards both by sector and regionally and of the level of work coming to tender stage in each sector. The three monthly analysis figures will bounce considerably as large contracts influence the numbers. The 12 months versus 12 months analysis provides a more stable view of the trend. Meanwhile, the comparison of the past 12 months with the five-year average should give a view of how the sector or region is performing against a recent historical norm.