Tonight:
9°c
Today's interest rate cut of 1.5 per cent stunned everybody. When the Bank of England Governor Mervyn King and the rest of the Monetary Policy Committee gathered this week for their monthly deliberation on interest rates, they could have been forgiven for thinking they had no decision left to take.
Never in the 11 years of the committee's existence had there been such a cacophony from the markets, from trade associations and from assorted gurus, all of whom were demanding an immediate cut in rates — to the extent that it was unthinkable that the Bank would not oblige.
It was odd to see all those Right-wing City economists, capitalists and free marketeers who had so welcomed the granting of independence to the Bank now queuing up to bludgeon it in the direction they want but that was the reality. But today the Bank routed even them. Not since the day of turmoil on Black Wednesday in 1992, when the UK left the ERM, has there been this big a move.
It is therefore a day of high drama. But as the excitement fades, as fade it will, the deeper question returns. No one who has thought deeply about it expects an interest rate cut to make much difference to the economic outlook. It is well known among economists that it takes two years for a move in interest rates to deliver a discernible effect on economic performance. The threat we face is one of imminent recession so a troop of interest-rate cavalry despatched now might arrive too late to affect the outcome of the battle.
As if that were not sufficient pause for thought, there is a further complication. In normal times the interest rate set by the banks provides a base which is used to set all other rates, one of which is Libor, the rate at which banks lend to each other in the wholesale markets. It is Libor which is also the benchmark used by banks in setting the rate at which they lend to companies, so Libor dictates the cost of money in the economy.
Normally, when the base rate moved, Libor would follow. But in these troubled times Libor has gone its own way, reflecting, if you like, the belief that it does not matter what the Bank of England says, no one can make the banks trust each other and lend to each other unless they want to.
The link still exists but it has become much more elastic, so while a cut in rates exerts a downward tug on Libor it could easily be a long-delayed reaction. Thus conventional economics tells us that a rate cut takes two years to affect the economy but this is only true if it is passed on. If the wholesale markets remain as frozen as they are currently, it won't be passed on for months and the impact could take even longer.
Libor does not affect all borrowers in the same way, though. There are lots of hard-pressed homeowners who would welcome having to pay less on their mortgages; some of them can look forward to some relief, although they are likely to get less than 1.5 per cent. In theory that should still give them a bit more money in their pockets and indeed it is that thought which lies behind many of the demands for a rate cut. The cutters believe — or profess to believe — that this extra money will boost consumer spending and therefore make the slump across the economy that little bit less severe.
But is this likely to happen? People have been told repeatedly that they have borrowed too much and need to save more. Can we really believe, after the battering the public has received, that they will throw caution to the winds, dust off the plastic and head for the high street just because the bank has cut rates? Even Sir Stuart Rose, boss of Marks & Spencer, or Sir Philip Green at Bhs, professional optimists both, would find that suggestion far-fetched. They and everyone else would surely expect the public in its present mood to use any extra cash to pay off a bit more debt, or even open a deposit account.
This indeed is one reason why this economic slowdown is likely to be a long-drawn-out affair. When companies are in trouble there are things they can do to recover quite quickly. They can cut jobs, sell assets and put up prices — and while it does not always work, because some companies will go bust, it gets a lot of them through the worst. With people it is different because they have so few options. There is no easy way for them to increase their incomes, and no easy way to cut their outgoings when so much is taken by mortgages, petrol and food.
In previous downturns like that of the 1970s they
were bailed out by chronic inflation, which ran at 26 per cent in 1975 and so cut everyone's debt by a quarter. But inflation is seen these days as the enemy, not the solution, even though this financial discipline condemns us to a long haul.
The British have turned themselves into the most indebted nation in the western world in the past 10 years, and our current problems will not be resolved until the nation's individual finances are collectively back on an even keel.
But don't hold your breath waiting for it to happen. If the Government had the money to deliver tax cuts, then that could make a difference to people's income, spending and saving, but we all know Gordon Brown's spending spree has blown that possibility and with it any chance of a quick fix.
In the other parts of the economy which are already in dire trouble, such as house building, a rate cut is unlikely to make much difference because the problems are too deep-set. If people are not going to go shopping for a winter coat, how much less likely is it that a cut of even 1.5 per cent in interest rates would unleash a sudden demand for new homes to get the house-building industry off its knees? We would do better here to look to the lessons of the Nineties recession and the last time house prices fell. They set off on the downward path in 1992 but it was fully 1996 before there was a recovery. Developers were giving away flats in Docklands as raffle prizes before the buyers finally returned.
None of this means, however, that what Mervyn's team has done has no relevance because the one thing interest rates can do is affect the public mood. Rate cuts have the power to make us feel better even if we know it's a fake — a bit like going to the theatre — so what he delivers and the style in which it is done can matter a lot. But here again there may be a lingering doubt. Having slashed rates by this almost unprecedented 1.5 per cent it could backfire.
In their present mood, people are likely to take it as confirmation that we are going down the plughole and get even more depressed. And if that happened next month or the month after, there could be a demand for an encore. Let us hope the Governor and his team have enough energy left to deliver one.
Reader views (7)
I can't figure out if I am missing out on something here, the only people who gain are tracker or variable mortgages, anyone on a fixed rate doesn't and will never gain from interest cuts, so there are loads of people out there who will only lose the savings interest and not benefit from the interest cuts !?
- Clare Jeffery, London
If borrowers pay less for their debts then savers recieve less interest. So the message is dont save but just borrow to spend. Why save if the rate is so low, so where will the money be to lend. What a mess.
- Ray, Brighton
Great. We have no mortgage, no credit card debt, no debts but we do have savings - so we are screwed again. Great country to live it. If you behave sensibly you are penalised.
- Sue, Wellington, UK
If the Debt Junkies have any sense left they should start paying down their debts.
- Get Shorty, Bognor
Rate cuts at present are the wrong way to go, but to be expected of the politicians/economists who got the UK into this mess in the first place; low interest rates in a non-manufacturing/high importing economy as is the UK now= high inflation. Also, surely the most important thing at present is to introduce tax cuts so that people can save more of the often meagre incomes they have, and put that saved money in a bank, and earn some interest, with decent interest rates-none of these issues are being addressed, just panic measures to lower interest rates, which may have the nasty side effect of devaluing sterling to ultra low levels-result-even more expensive imports, including essentials like food and oil.
- Jon Kent, Hertford. UK
Isn't this one of the reasons that got us in this mess in the first place - very low interest rates for too long? Great plan, lets all keep borrowing some more and spending!
- Sanjay, Singapore
Article probably needs rewriting - we are starting to feel richer again. Petrol down, food down, mortgages down. Interesting to see how this plays out in the property market.
- Gazza, england
