Thursday, 6 November 2008

Bank of England cuts base rate by an unexpected 1.5%

At lunchtime today the Bank of England announced a change in the base rate of -1.5 percent, taking the rate to 3.0 percent; the markets and media had been expecting a cut between 0.5 and 1.0 percent. The immediate effect on the markets was to boost the FTSE 100, this fell back within a couple of hours, and, strangely, a boost of sterling versus the US dollar, which so far has been sustained.

We must ask: why did the BoE cut by such a massive amount, and what will the effect be on the economy? (Not since 1955 have we had interest rates so low!)

First: why make such a large cut? The BoE is supposed to be targeting inflation as measured by CPI. At 5.2 percent CPI is currently more than twice its 2.0 percent target. The BoE has largely been ignoring this for a while now. However, thanks to the dire economic situation CPI is likely to fall of its own accord. About a year ago there were big increases in the cost of oil and food. These upticks will drop out of the index shortly. There have also been recent big falls in the price of oil (from $140 to $60 per barrel) and these falls will dominate the index for next year or so. The BoE can therefore claim to have the lid on inflation by this arithmetic trickery. Hence it is open to them to cut the base rate. Some insiders are claiming they may actually undershoot the 2.0 percent target in the coming months. It’s also worth remembering that although we won’t see a new CPI number for another 12 days the BoE already has sight of some early data.

The reduction in the base rate gives the government several short-term benefits:-

Christmas boost. The holiday shopping season has widely been predicted to be a complete wash-out. Giving consumers more money to spent may buy some limited and temporary relief for the retail sector.

Bank capitalisation. Banks are likely to respond to the cut by applying it in full to savers but only in part to borrowers – except people with base-rate tracker mortgages who are big winners in today’s announcement. By increasing their slice of the pie banks will rebuild their balance sheets and need less financial help from government. (Various government ministers have been on the media claiming banks should pass on the cut in full to borrowers, but it’s not really in the government’s interest for this to happen.)

Relief to mortgage-holders. The government would love to kick start the housing market. They may be hoping this cut will do it. (It won’t.)

Feel-good factor. Let’s not forget that there is a by-election today. Labour is defending a 10,664 majority in Glenrothes, Fife. This cut may swing a few votes.

Cost of public debt. At the start of the year the UK’s national debt was approx £620bn (not including all the fudged figures in public-private partnerships and the like.) Since then the government has committed to a vast amount of additional spending financed by borrowing. Add the cost of Northern Rock’s nationalisation, the Bradford and Bingley rescue, the Icesave compensation and the stakes the government intends to take in many of the major banks and you can add anywhere between £100bn to £200bn to the public debt. The government budgeted £30bn this year to pay the interest on their debt (which incidentally they’ve increased from £400bn over their term in office.) Clearly £30bn isn’t going to be enough. Cutting interest rates will help them out of this hole.

And now we turn to what the economic effect of the cut will be.

Most mortgage-holders will see some benefit. Those with trackers will see the full amount; and LloydsTSB has announced it will pass on the full amount to its standard variable rate customers. People on fixed-rate deals, usually locked in for 2 to 5 years, will see no benefit. Unfortunately this is almost half of all mortgages. So some High Street benefit can be expected from the cut.

By rights sterling should have fallen sharply on the announcement, but it didn’t. The markets probably priced in most of the cut a few weeks ago. Sterling has dropped considerably, especially against the US dollar, recently, down from $2.10 a year ago, to $1.56 this week. The bit they didn’t price in, the 0.5 percent surprise, may be offset against the gain of more consumer spending. The BoE and government must be praying that sterling holds up. If it doesn’t CPI won’t fall as expected and today’s gamble will have failed.

The big losers from today’s cut are savers. In theory savers are the motor of the economy; savings are used to fuel business and industry. Under New Labour the habit of saving has been lost and the economy has been fuelled by borrowings from overseas instead. So the government has fairly complacently ignored savers. With CPI at 5.2 percent (last published number) and the base rate now 3.0 percent all savings are going to lose 1 or 2 percent of their real value per year, which is very annoying for savers but there’s not much they can do about it.

Ultimately an economy running nicely needs savers; they can’t be ignored. But this government is only really concerned about the short term. Their horizon is never more than 3 or 4 months out. They are damaging the country by continuing to fuel the economy with borrowings but forever pushing back the day of reckoning by every more desperate measures. The public debt taken on this year alone will be decades in the repaying.


Anonymous said...

And one other effect - boosting support in the Glenrothes by-election.

Anonymous said...

A great article! It's a fantastic blog for reading up on the financial situation.

AgainsTTheWall said...

Im really not an economist but I hope you will indulge me while I air a few half-baked thoughts.

The CPI does nt really measure inflation. The best measure is the money supply and the govt's determination to borrow shedloads will increase this quite dramatically over the next 18 months or so. Inflation must rise sharply in the unlikely event that production does not expand in proportion.

In recent times (genuine)inflation has been in house prices, fuelled by easy bank lending (and dishonestly excluded from the CPI).

With govt responsible for spending the increase in money supply the effect will be seen elsewhere (though tbh Ive no idea where).

A final factor is the value of sterling. It may take a little while before it loosens but it must inevitably fall further with detrimental impact on the price of imported retail goods.

The British economy is a crock and its parlous state is the result of decades of selling-out to 'free trade' and 'globalisation'. Ultimately nothing Gordo and his cronies can do can shore up an economy that produces nothing and has chosen to live on debt.

I echo UBNs thoughts.

Nationalist said...

I certainly agree that the money supply is a better measure of inflation than CPI. Over the last decade we've had the money supply growing at about 13% while the economy was growing at 3%. That's 10% more money chasing the same amount of goods and services, ie, 10% inflation.

It didn't show up in CPI because house pricew don't figure in that index. (Rents do but they've been restrained over the last ten years.)