The Hindu Business Line : BoE rate-cut: Barking at the moon?

Intriguing is the seeming anxiousness of the UK government to get the people borrowing and the banks lending when this is what pushed the whole system into the mess that it finds itself in.

J. Srinivasan

In what is being hailed as an unprecedented move in more than half a century, the Bank of England on Thursday (November 6) cut interest rates by 1.5 percentage points, beating the most optimistic expectations by half a percentage point. Economists who were for the cut — the large majority it would seem — are congratulating themselves and patting the Bank of England (BoE) for doing what they had been suggesting for a while.

Will it help?

Good, but will that do the trick? Most newspapers were plaintive in their appeal that banks pass on the rate cuts to the borrowers, old and new. Some news reports even gave the spin that the politicians were at the bankers’ throats to loosen up the lending rates. Herein lies the problem. Banks are not willing to do so. Most have told the government as much while two have promised to cut their own lending rates.

The government wants to show that as it has taken billions of pounds of people’s money to recapitalise banks, it is working to ease their burden. Before the financial crisis, the relationship was fairly direct.

Most mortgages were on tracker rates (that is, they tracked the central bank rate with a spread of one or one-and-half basis points) and would more or less faithfully move in tandem with the base rate. So a rate cut could be expected to be reflected in lowered mortgage rates. That is, put money in people’s hands, as intended. No longer.

For, as the inter-bank lending market is completely enervated, with confidence at low ebb, the overnight rates have not come down with the base rate.

The Libor, or the rate at which banks borrow from one another, remains high. That is, for most banks the cost of funds has not reduced as dramatically as suggested by the BoE’s rate cut. Since inter-bank lending is now the key source of fund, the problem remains.

Whom to lend?

Then, the case of the people. Would banks willingly lend to anybody but the prime borrower? In the current environment of severe job-cuts and/or wage reductions, it is doubtful if a bank will find many such clients.

And the lucky few that remain prime would already be fully leveraged. In these uncertain times, only the really bold will go courting a loan. Anyway, anticipating the BoE rate-cuts, most banks have withdrawn the tracker lending instruments.

This is angering the vast majority of Britishers, who are not taking too kindly to banks helping themselves to the people’s money but refusing to pass on the benefits.

However, this argument has another side to it: Bankers have taken someone else’s money to recapitalise themselves so they cannot very well fritter it away by lending it to all and sundry as they did earlier and came to grief. They are thus reluctant to loosen their purse.

Panic response

So is the Bank of England’s rate-cut barking at the moon? If anything the dramatic rate cut was seen as a panic response. Which is why the FTSE 100 lost 5.7 per cent post the BoE move.

From the reaction, the market could be legitimately worried that the government has, or suspects, more bad news. Not that there has been any dearth of them in recent times, with the IMF suggesting a minus-1.3 per cent growth rate for the UK for 2009. Manufacturing output in September was down to 0.8 per cent, the lowest in 12 years, while unemployment was highest in two years.

Yet, then, why did the BoE do it? One, it could be a political decision and that raises serious questions about the independence of the BoE, which is supposed to be uninfluenced by the government. But circumstantial evidence suggest otherwise. For the Chancellor of Exchequer, Mr Alistair Darling, just last week spoke of the need for such an action.

Two, some economists suggest that the government has finally woken up to the fact that what it had been doing till recently — adjusting the rates in quarter percentage points with an eye on the inflation — is completely wrong and that it is correcting that. Indeed, many think the quantum of the latest cut may have taken England ahead of the curve. They trot out the case of Japan in the 1990s when it is thought to have delayed the rate-cuts too long to have any useful impact and the economy deflated.

Third, the nine good men and women of the Monetary Policy Committee that decides on the rate-cut simply do not want to be the ones that pushed the economy into recession by being parsimonious about the rate cut. Their thinking seems to be: This is what almost everybody seems to want, so give it.

Fourth, the BoE is simply taking a gamble, and hopes the rate-cut would do the trick and get confidence back in the banking system.

This is perhaps the closest to what is happening for no one really has any idea if the financial crisis has unravelled fully.

Bleak outlook

The outlook for the UK is abysmal and if some thing more happens, from inside or outside, the economy could keel over. Keeping interest rates high could be that last straw. The BoE would do its bit even if it cannot do much about the external threats.

The BoE rate-cut is predicated on the inflation rate coming down with the crashing of commodity prices, especially of crude oil. But what if for some reason oil prices rise and fuel the inflation monster? It could be catastrophic for Britain.

But most intriguing is the seeming anxiousness of the UK government to get the people borrowing and the banks lending when this is what pushed the whole system into the mess that it finds itself in.

A case of using petrol to put out fire?