Interest rate cuts won't work

Over the last few days, the calls for dramatic rate cuts have bordered on the hysterical. Apparently, if the Bank of England does not cut rates massively now, the world will fall into the greatest recession since the big one back in the 1930s.

There is an obvious flaw to this piece of desperate policy advice. The US central bank has already experimented with some massive rate cuts, and so far, those cuts have proved to be astonishingly ineffective at preventing a slowdown.

It is not hard to see why. The above chart compares two important US interest rates. The first is the effective federal funds rate. This is the rate that the US has been offering as part of its daily monetary policy operations. The second interest rate is the long term corporate bond yield for companies with a reasonably good but a not perfect credit rating.

The story is horribly clear; the central bank have cut short term rates almost to zero, but the long term rate faced by companies has actually increased. Those manic Fed rate cuts have been utterly ineffective in terms of reducing borrowing cuts for firms.

This should be unsurprising. Banking crises destroy the relationship between interest rates and the real economy. Banks in trouble don't go out and start new lending. Rather they cover up bad loans by issuing credits to existing customers who might be finding it difficult to make the interest payments. Credit often grows during banking crisis, but only in a malignant and unhealthy way.

Banking crises distort credit creation, which translates into higher risk premium on corporate lending. In economies with dysfunctional financial markets, lending to companies becomes more risky. Therefore, cutting rates can not prop the economy up when the banks are sliding towards insolvency. This is what the Fed has just found out after a year of negative real policy interest rates.

So why did the Fed cut rates so dramatically. It is the old fat spread trick. Bernanke and the gang wanted to increase interest margins as a back door way of recapitalizing the banks. They wanted to put the cost of the banking crisis onto savers who would receive negative real interest rates on their deposits while banks would maintain lending rates.

However, it hasn't worked. The banks are as insolvent as ever. That is why the strategy changed this week, when Bush announced that the government would start injecting new liquidity into US banks.

So, the MPC can cut rates to zero, but the policy won't stop a recession until the banks are sorted out. Firms will continue to face high borrowing costs, and investment will contract. However, low interest rates will destabilize household portfolio decisions. People will not save, and they will hold more money as cash rather than bank deposits.

What will low rates and a banking crisis do to inflation? The simplistic view is that declining credit growth will lead to a fall in aggregate demand and ultimately declining prices.

Unfortunately, things are a little more complicated. Banking crisis are associated with huge liquidity injections, that begins by sitting on bank balance sheets. However, people are forward looking creatures, they know that this massive amount of new money will lead to higher prices. That expectation affects price setting behaviour today. People begin to increase prices today because they know that all that idle money will eventually feed into the real economy.

Sure enough, we are 14 months into the credit crunch, the UK economy has stopped growing, while the US economy is now in recession. What is happening to inflation? It is at a 16 year high in both countries.