Friday, 14 November 2008

Will the rate cuts work?

During the last two months, the MPC cut the bank rate by two full percentage points. However, will these mad cuts translate into lower borrowing costs for customers?

The chart above tracks effective bank borrowing rates. The data ends in September and therefore excludes the recent 2 percent reduction.

However, three things scream out from this chart. First, earlier rate cuts had a very limited impact on effective borrowing costs. Banks were reluctant to pass on the cuts, preferring to increase their margins and try to work off those bad loans with higher interest income.

Second, in nominal terms, rates today are not that high. Certainly, rates are higher than the crazy days of 2004 when banks were practically giving money away. Nevertheless, rates today are still significantly lower than in 1999-2000.

Finally, when today's rates are adjusted for inflation, then they begin to look extremely low. With inflation running at 5.2 percent and effective rates at 6.8 percent, the real cost of borrowing money is extremely low.

These latter two observations raise a troubling question; why are UK banks in such trouble? If rates are so low, in principle lenders shouldn't be having too much difficulty paying off their loans. This point is confirmed by default rates, which remain comparatively low in historical terms.

The answer to this question has several layers. First, the banks pushed their lending to the maximum and they have only a limited capital buffer to absorb costs. Second, default rates might be low today, but with the economy in recession, that number can go in only one direction - up.

Hence, the mad rate cuts in recent weeks. The Bank of England wants to lessen the debt serving burden on borrowers. Actually, they want to do more than that, it would like to see negative real interest rates, whereby savers pay off the debts of troubled borrowers. It is a deeply dishonest policy that rewards extravagance and risk taking and punishes prudence and honesty.

So will these rate cuts work? They might bring some temporary benefit to some struggling borrowers. In the long run, negative real interest rates will discourage saving, reduce investment and leave us all much poorer.


Anonymous said...

This government hates savers.

John Pickworth said...

I could be mistaken, but I don't think 'The Spender of First Resort' is reading your blog?

Brown calls on Bank to cut interest rates again

You gotta laugh... well, unless you're a saver of course?