Speeches and interviews by Monetary Policy Committee (MPC) members Michael Saunders, Jonathan Haskel and Gertjan Vlieghe plus the CPI for December coming in at 1.3%, some distance below expectations, have raised the probability of a 25 basis point cut in the Bank of England base rate at the next MPC meeting on 31 January to 50-50.
Our own analysis last week pointed to a very weak level of Christmas sales and huge discounting in January with the prospect of a further fall in CPI inflation. So in theory we should be supportive of a further cut.
But in fact we are sceptical. This note explains why.
Essentially a rate cut works through four mechanisms. It discourages savings; it boosts borrowing; it weakens the currency and it boosts asset values.
We believe that after a long period of ultra low interest rates the first two mechanisms have long ceased working. Since bond yields have already fallen we would be surprised if asset values rise much on the news of a further rate cut. The currency would probably weaken, although much of this has already happened on the anticipation.
Net, therefore, it is hard to see a rate cut having much of an impact on the economy.
There is an argument that rates should have been allowed to normalise during the upswing of the economic cycle. The difficulty here is that the exchange rate is driven by comparative rates and with most other economies keeping rates down it would have been very hard for the UK to move on its own without risking a distorting rise in the sterling exchange rate.
Our underlying analysis is that there is a worldwide demand deficiency that has kept rates low caused by international conditions (a rising share of the world economy is now happening in places with culturally high savings rates) and by banks’ unwillingness or inability to lend resulting from the financial crisis. Low interest rates are essentially a cyclical policy that gradually loses its effectiveness over time and that has been put in place to counteract a structural problem. The problem we now face is that the effects of the cyclical policy are wearing off while the structural problems still remain.
There is no easy answer to this. It is possible that pro borrowing policies in the emerging economies will remove the demand deficiency from that source. There is some (if limited) scope for fiscal expansion in a number of economies, particularly Germany. And it is possible that other methods of monetary stimulation will boost demand in the UK and other countries as they have in the US.
Our fear is that relying excessively on boosting asset markets to stimulate demand will create a bigger bubble which means that when the bubble bursts the recession will be deeper.
So it is hard to see the case for the latest proposed interest rate cut. It probably won’t work. But if it does it will create the risk of a bigger recession in the early 2020s.
Contact: Douglas McWilliams firstname.lastname@example.org phone: 07710 083652