Volume 01 (2009, Week 01)

Interest Rate hits all-time low
Bank of England cuts interest rate (again).

On this Thursday (8th of January, 2009), Bank of England (BoE) announced a further interest cut of 0.5%, bringing down the base-rate to 1.5%, the lowest level for its entire history of 315 years. The cut was widely anticipated.

Bank of England (BoE) has been cutting the interest rate aggresively (maybe little bit too aggresively) since 8th of October, 2008 amid the fear of economic recession in the UK. In early October, the interest rate stood at 5.0%, but it has been cut by 0.5, 1.5 and 1 percentage points in October, November and December respectively.

There are two main motivations behind all these bold interest-rate cuts: (1) to increase the spending of individuals and (2) to make credit more affordable to the businesses; both in order to boost the economy, or rather to make the recession milder in this case. The technical term for this kind of action is known as expansionary or loosening monetary policy.

The expansionary monetary policy works like this: it seeks to increase the total money supply in the economy, therefore increasing the money circulation which leads to increased economic activities and increases the economic output (or consumption). At least, that's the theory. In most countries, Central Banks have the responsibility for the monetary policy (BoE and its Monetary Policy Committee (MPC), which consists of 9 people, are responsible for the UK monetary policy).

Enough about the background and boring stuff, and to the big question: "Is it working?". In ordinary situations, let's say 2 years ago, such a policy would have had a large impact on the economy and probably would have driven the inflation far too high. But so far, the impact in the last 2 months have been very little, if there has been any impact in the first place.

Of course, the are beneficiaries from these interest-rate cuts: borrowers - people who have got mortgages, and any other type of loans as well as businesses, most of which are in operation thanks to credit. However, not everyone has got a tracker mortgage, meaning there will be many people who simply would not benefit from the cut. In fact, the majority of the mortgages in the UK are on fixed-rate. Also, not all the banking and lending institutions are going to pass on the full interest-rate cuts (that is total of 3.5 percentage point cut since October last year) to those who are on variable-rate, simply because some of them cannot afford to cut it.
It is unlikely that consumers are going to spend everything they have gained from these gains due to lower payments on their mortgages and loans, which means the expansionary policy could fall short of what it tried to achieve.
According to Paul Lewis, the presenter of BBC4 Money Box, there are already 88 savings accounts offering 0.5% interest rate or lower (see UPDATE). Surely, the full interest-rate cut can not be applied to those savings accounts. This will squeeze the profit margins of already struggling banks and other lending institutions.

In my opinion, whatever result comes out of all these cuts in the short-term, the long-term effect is going to be disastrous. The are 2 main problems:
First, it is penalising the savers, who have been prudent in the over-spending and over-borrowing period. It is the savers, who can potentially save the economy as they provide the very money available for businesses and individuals to borrow. The low interest-rate will discourage the savers and if this low level of interest rate is sustained for long-period, it can be fatal for the UK economy, as the already low level of savings-rate can go down even further, making another credit-crunch in the future very possible.
One group of losers is going to be pensioners, who supplement their pitiful state-pensions with the interest-rates earned from their life-long savings. They may well be forced to start withdrawing larger amounts of money from their savings as their income on the interest-rates dwindle.
Second, we are in credit-crunch! For the past 18 months, we have been talking about credit-crunch, and there is not enough credit out there. The only thing interest-cut does to credit is, it makes the credit cheaper, and it is not increasing the availability of credit. There is not much of a point trying to make something cheaper, which doesn't exist!

From a different perspective, the pound-sterling has been depreciating against the euro and US dollar dramatically. This helps the British firms, as it makes the British exports cheaper abroad, hence more attractive and given that the USA and Eurozone countries make almost four fifth of the UK international trade. The fall in the value of pound can partially be attributed to aggressive interest-cuts of BoE, while European Central Bank (ECB) has been much slower in cutting its base-rate, now standing at 2.5%, although it is expected that it will be cut further next week (see second UPDATE). This means, the interest-rate cut may be helping the UK economy from a very different angle than the BoE intended to.
However, we don't know how much impact the interest-rate had on the exchange-rate. Indeed, the pound has started falling sharply agains the US dollar from August 2008, well before the interest-rate cuts started. Also it has been falling against the euro ever since the introduction of euro in 1999, although recent fall has been far sharper, that it could be called currency-crisis as it has tumbled by more than 20% within 2 months up to 29th of December 2008, where it hit all-time low of only €1.0198. So given the time frame of this sharp fall against the euro and slow interest cuts from ECB, the impact of interest-rate cut from BoE on the exchange rate could well be significant.

As far as winners and losers are concerned from these interest-rate cuts, the losers will be more than the winners, at least in the long-term. The positive significance of this week's cut is probably only historic.


Related articles:
Interest Rates Hit All-Time Low, BBC News | Business
Combating the Recession, Economist | Britain
Does the Bank Rate Matter? (Rober Peston)

UPDATE (on 12th January 2009):
According to Moneyfacts, 60 instant access accounts - 17% of the total - pay just 0.3% or less on sums up to £5,000. Of those, there are three banks or building societies that pay nothing at all on some of their accounts, one that pays 0.001% and six that pay just 0.05%.
(Full article)

UPDATE (on 15th January 2009):
As expected, European Central Bank (ECB) has cut its interest-rate to 2%.