Monday, 8 December 2008

The true cost of lower interest rates

The Bank of England are playing a very dangerous game with interest rates. The flow of cash into personal bank deposits has dried up over the last four or so months.

Before May 2008, UK high street banks could confidently expect an inflow of at least ₤2 billion every month into personal bank deposits. Since then, flows have become highly irratic. In October, flows were marginally negative.

It is now public policy to penalize savers. Negative real real interest rates and witholding tax have more or less destroyed any incentive to save. The government wants us to forget about the future and spend everything we have today. UK savers are behaving perfectly rationally, they have stopped putting new money into bank accounts.

Banks are now caught in a dilemma. Brown wants them to cut mortgage rates and keep on lending. The FSA wants them to build up their capital. The Bank of England have cut rates to ensure that anyone who has the temerity to save will be ruthlessly punished. In short, how will banks fund this additional lending when savers are beginning to desert traditional forms of savings.

None of it makes much sense.


Anonymous said...

British pound falls to new lows on currency markets
By Ann Talbot
8 December 2008

In the run-up to the interest rate cut, the pound fell to US$1.45. This is its lowest level against the dollar for six years. As recently as July the pound was trading at US$2.00. From its peak, the pound has fallen by a total of 30 percent against the dollar.

The pound hit its lowest ever level against the euro at €1.1 and a 10-year low against the Japanese yen. It has lost 45 percent of its value against the yen since last summer. The extent of the fall in the pound is comparable to its collapse in 1992, when it was forced out of the European Exchange Rate Mechanism.

In the long run we are all dead.
John Maynard Keynes quotes


Anonymous said...

Does anyone know the amount of borrowing, particularly on mortgages, vs the amount of money on deposit at banks and building socs? Surely if rates go down the amount saved by mortgage holders in reduced payments will be balanced by less income from savings for people with deposits? So the impact on the overall level of spending in the economy could be small, or even negative?

spl0it said...

Are you forgetting that millions of people knock off years or save extra money on their mortgages everytime the rates fall? Don't forget business who's cost of borrowing drops and can end up saving boat loads of money. As a saver myself I welcome the interest rates dropping because loans and mortgages become easier to handle and quicker to pay off.

Anonymous said...

There are still some fixed rate deals around at about the official RPI rate. I reckon its better to pay down debt at these pitiful interest rates. Got a problem with ISA ringfenced cash however, as don't want to remove the tax exemption.

Howerver, its the lemon value of our money abroad that gets me most of all. I've been anywhere I wanted to go on this island, and now I cannot afford a trip to Amsterdam any more. I wonder when it will cost more to make British coins out of chocolate than their face value?

mike said...

Sobers you ask a good question. One data set of data from the BBA suggests deposits in high street banks total 568bn, whereas the mortgage lending totals 525bn:

However BOE data suggests about 1.2 trillion in deposits (total) and 1.5 trillion in total lending. Hence a huge 300bn shortfall:

I don’t quite understand where the shortfall is coming from. Sounds like the economy is very ill!

According to the BBA statistics it seems it would not take much of an outward flow of cash from the UK to other countries to cause more problems for high street banks. As the base rate goes lower compared to the ECB rate then the Eurozone banks become more attractive for saving. At the moment the difference is only 0.5% and generally I have seen Euro banks being less generous than UK banks on interest rates for savers. But if the rate goes much lower then you might start to see big investors shifting their money. Just like Richard Branson did with his Virgin Atlantic billions of customer deposits which nearly wiped out HBOS when he tried to move the deposits to another bank!

Generally I would expect the government would take more tax from savers since they tax the interest on savings and when the savings are eventually spent it is often taxed again through VAT. Also people who borrow money can often offset the interest payments against any tax due. So the strategy to lower the interest rates is the wrong one which may backfire badly.

Anonymous said...

@spl0it - if you have mortgages and loans to pay off, you're a borrower, not a saver.

Wait till you've paid them off and see how you like 0% interest.

Anonymous said...

Mike: assuming your figures of £1.2tn in deposits and £1.5tn in debt are representative for the UK, then for a 1% cut in interest rates, borrowers gain £15bn, whereas savers lose £12bn (assuming rate cut is passed on 100%), for a net effect of spending capacity of +£3bn. Given the UK economy is approx £1.4tn, and the govt spending is £600bn, £3bn is a bit of a rounding error. Also generally (as we are finding out) rates are cut less slowly for borrowers than for savers, so the net figure will probably be less than £3bn.

All it is really is a transfer of wealth from savers to borrowers. Why is this never pointed out, or considered to be a bad thing by the media or politicians?

Anonymous said...

All part of the government's plan to force the banks into nationalisation.

Anonymous said...

The UK is bust: I am now earning in Euros and dollars and saving outside the UK. I am also spending (apart from food and rent) outside the UK. The UK is no longer worth it.

Anonymous said...

Hi Alice,
Yeah not sure it makes much sense. Central banks talk of the zero bound where rates are cut to 0%. But if this creates a liquidity trap, penalises savers and becomes as effective as "pushing on a string", what is the point?