Big Mistake by BoE.....Again!!

Why the Bank of England's latest rate cut is a big mistake
By Associate Editor David Stevenson Feb 05, 2009

Further cuts could do more harm than good
Even before midday today, Britain's 1.5% base rate was at its lowest since the Bank of England was founded in 1694. Now the rate's just been cut again – to 1%. And the siren voices of the construction, retail and manufacturing industries will be telling us what good news this is, and will be clamouring for even more rate reductions.
Trouble is, this rent-a-mob's got it wrong. The latest rate cut will do much more harm than good. Here's why.

Low interest rates are doing much more harm than good

Firstly, low rates are dreadful for savers. Remember them? They're the ones who didn't borrow all they could and then, when the going got tough, threw in the towel and bleated for a bail out. They're also the people who kept Britain's banks going before HM government stepped in using taxpayers' cash to keep lenders afloat.

So how have we rewarded savers? By slashing their returns to zilch.


It was time to call a halt. And to be fair to the Building Societies Association, this week it's been urging the Bank not to cut rates any more, pointing out that its members provide more than 20% of both UK savings accounts and mortgage lending. So lower interest paid to savers means less chance that they'll keep their cash in the building society. Which in turn means fewer funds available for borrowers.

Sadly, the Bank of England didn't listen.

What's more, lower interest rates aren't even helping that many borrowers. Even the banks prepared to lend any money these days are being very cagey about passing on the rate cuts. Yes, Barclaycard cut some of its borrowing costs yesterday, but its average rate is still almost 12.5%. So all the Bank's rate reductions are doing is fattening bankers' profit margins, and no doubt their wallets to boot.

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The damage caused by the weak pound
Then there's the serious damage to the pound. If you've been making holiday plans outside the UK this year, or if your income depends on imports, your costs will have soared as the pound has bought less and less.

At some stage, that's going to help stoke up inflation again. More on this another day. But right now, another rate cut will just do more damage. Just as with domestic savers, even lower rates mean lower returns for foreign holders of sterling, and so less reason for them to hold our currency. And that tends to be self-feeding, i.e. the more the pound devalues, the more reluctant external holders are to own it.

And don't be fooled by the "it doesn't matter if sterling drops" brigade.
It does. Our national debt, i.e. the amount of money we owe the rest of the world, is set to shoot well over £1 trillion within five years. And that's on the official numbers, with the real ones likely to be even worse. So, like it or not, as a country we'll have to borrow vast amounts from abroad, via the government flogging hundreds of billions of pounds-worth of gilts.
There's no way that'll happen if outside investors don't want to invest in sterling assets. Unless of course, we have to entice them by paying much more. In other words, cutting the base rate is simply forcing up the long-term rate of interest that we'll have to shell out.
Then there's those banks who won't lend, mainly because they're terrified about the state of their own finances. At the last count, British banks had borrowed $4.4 trillion from international lenders, according to The Telegraph's Ambrose Evans Pritchard. That's eight times the debt of the bust US investment bank Lehman Brothers.

It's very unlikely that these banks' assets will be appreciating in value as fast as their liabilities are rising. A further sizeable sterling drop could wreak havoc with their already ultra-fragile balance sheets.

Let's hope the Bank of England has learnt from Japan's mistake
But there's also another reason, less tangible, but maybe the biggest of all. And that's confidence. When the general public sees the policy makers panicking, they get the jitters even worse themselves. As Dr Ros Altmann said yesterday, "this negative effect far outweighs the positive possible impact of encouraging already over-indebted consumers to borrow and spend more by lowering interest rates".

On this point, just remember what happened when the Japanese cut interest rates to nearly zero in 1995. All that succeeded in doing was shattering confidence so badly that the economy suffered the so-called "lost decade" of collapsing property and share prices. In fact, the Nikkei 225 index is now no higher than it was fully 26 years ago.
The bottom line? Lowering interest rates from 5.5% made sense. This rate cut is a big mistake.