Interest rate cuts do work!

In all likelihood the Bank of England will cut interest rates today at the end of the monthly meeting. The MPC has not been as proactive as the United States Federal Reserve in aggressively easing monetary policy but a reduction in the cost of borrowed money will act as a stabilizer for confidence and demand as the economy softens. It is at times like this that we need to remind ourselves of how cuts in interest rates work their way through the economy. And also to remember that base rate changes do work even if, this time around, the policy-makers may have to do a little more than in the past to smooth the extent of cyclical volatility. Monetary policy is not yet impotent!

Lower interest rates work through several different channels - there was a fine graphic of the transmission mechanism of monetary policy in a research note from the team at Deutsche Bank published last week.

(1) A reduction in the cost of borrowing ought to stimulate consumer spending and capital investment spending.
(2) Lower interest rates (other factors remaining constant) tend to raise asset prices including equities and property, which again raises consumer and business spending through increases in wealth.
(3) Lower interest rates reduces the cost of servicing debts such as mortgages, hence people have more money to save which then increases bank deposits which raises the availability of funds for bank loans
(4) Lower interest rates cause the currency to depreciate, which stimulates aggregate demand through higher net exports (X-M). We discussed some of the benefits of depreciation in the sterling exchange rate in a blog earlier on this week.

Naturally there are time lags between announcements of cheaper money and this feeding through into confidence, spending, output and jobs.

The concern at the moment is that running an expansionary monetary policy (with official policy interest rates below their estimated ‘neutral level’) might have less effect on the real economy because of the special circumstances that exist right now.

(i) Short term interest rates might be falling, but long term interest rates seem less unwilling to fall - partly because of ears of rising inflation
(ii) This time, there is significant downward pressure on house prices - in contrast to the last time interest rates were cut in the wake of the bursting of the dot.com bubble
(iii) Many lenders appear reluctant to expand their balance sheets by extending extra loans to new borrowers

The good news is that the impact of interest rate cuts can shown through quite quickly in key parts of the economy

(a) A fall in the debt payments on new motor cars and expensive household durables
(b) A reduction in the cost of paying monthly mortgage interest payments
(c) The UK currency has depreciated and is expected to move lower if and when the Bank of England eases rates down this spring

In short, the Bank of England is between a rock and a hard place. Sensible interest rates cuts now will moderate the depth of the looming slowdown. But it wants to avoid stoking up inflationary risks in the next 12-18 months. Most important of all is that realization that a slowdown is not an economic disaster - indeed the economy needs to rebalance itself away from domestic ‘credit-fuelled’ consumption towards savings, capital investment and growing the export base of the economy. A small rate cut in February will help that process.