BoE makes a dramatic 1 1/2 point cut
The Bank of England has cut interest rates to 3%, a 1 1/2 point cut. Just weeks ago, the BoE Governor Mervyn King was writing to the Government explaining how they had let inflation run out of control. However, with the economy tanking, credit short of hand and commodity prices plummeting, the Monetary Policy Committee (MPC) has decided to make a dramatic move to support the economy. Inflation is yesterday’s news.
I have had a bit of running debate with Alice Cook from UK Bubble about MPC actions. I have argued that the BoE wanted to cut rates and was looking for a reason to do so. On the other hand, we both agreed that low rates are the problem and not the solution. The political pressure was to great and the BoE has indeed cut — and in dramatic fashion. I can only imagine what Alice thinks about this.
In my view, it is only a matter of time before the European Central Bank succumbs to this pressure. Welcome to the world of deflationary worries.
UPDATE: The ECB cuts 50 basis points.
Last month it cut rates from 5% to 4.5% in an emergency move co-ordinated with other central banks.
There had been widespread calls from industry for a major cut as the country begins to face up to the prospect of a deep recession.
It is the most dramatic cut since a two percentage point reduction in 1981.
‘Bigger than expected’
The cut comes after a raft of weak economic data recently.
It is the first time the Bank has cut rates by more than half a percentage point since gaining its independence in 1997.
BBC economics editor Hugh Pym said: “The Bank of England is using terms like ‘very marked deterioration in the outlook’ and ‘severe contraction’.
“It is clearly very concerned about the possibility of a prolonged recession in the UK.
“The risks of high inflation have now evaporated, and because the bank is worried that inflation will now fall well below its target, it has felt the need to come up with this cut, which is much bigger than expected.”
‘The right call’
The move has been broadly welcomed by business bodies and trade unions.
Richard Lambert, CBI director-general, said: “This is a bold and welcome move by the Monetary Policy Committee, and achieves what the CBI had been calling for.”
He added: “This cut… should help to ease conditions in the credit markets, and allow banks to pass the benefits on to their customers.”
The TUC’s head of economics Adam Lent said the move was “the right call”.
“It shows the Bank now understands that the problem is recession not inflation.”
Meanwhile, the Institute of Directors said interest rates could touch record lows of 2% or less by this time next year.
“The sooner we get interest rates down the less is the risk of a long and deep recession,” said IoD chief economist Graeme Leach.
Source
UK interest rates slashed to 3% – BBC News
In the short term, I’m not sure what Alice has to worry about. UK house prices are still falling precipitously. And yesterday’s 3 month LIBOR is still as high as it was when BoE rates were at 5.5%. The whole monetary policy mechanism seems to be very broken, with all the banks hoarding cash.
The immediate risk is a run on Sterling, but run to where? Gold? The central banks behind all the major currencies are cutting rates.
The long term risk is high inflation but this may not happen until next year. Today’s IEA long-term prediction for oil predicts we”ll see $100 oil again but doesn’t attempt to pick a year.
My fear is that banks may suddenly overcome their fear of insolvency, open the floodgates, and release all that cheap money that’s been pooling up on their balance sheets. Inflation will then shoot up in a short period of time. Is this even plausible? Will the BoE be able to react quickly enough? And what effect would such huge swings in interest rate have on an economy?
I saw the IEA forecast and thought it smacked of self-dealing. I certainly agree with their conclusions but the timing was very suspicious given how oil prices are now so low.
As for Alice’s viewpoint, I have a lot of sympathy for it. As you indicate, inflation is what one should expect from the money flooding into the system from central banks. But one should also expect risk-taking from interest rates that are being cut too aggressively.
Have you seen the talk about leveraged ETFs?. I am hearing chatter on the back channel about how reblancing portfolios in order to accommodate these ETF positions is creating wild swings at market open and market close.
This type of leverage (now 3x as well) is a direct result of easy money. Interest rates are too low and this has spurred risk taking. All of this will end very badly.
And your fear of banks’ insolvency concerns dissolving are well placed. The monetary stewards are trying to increase risk appetite in a way that is dangerous.