The Bank of England’s interest rate decision today would, in more straightforward times, have been an easy one.
With wage growth declining, GDP growth stagnant, and inflation at 1.3 per cent, which is far lower than the bank’s remit of 2 per cent, historical precedent pointed strongly to rates being cut.
Lower interest rates, according to economic theory, should boost GDP.
The rate at which cash moves through the economy is called the velocity of money, and lower rates boost the velocity. If the velocity of money is rising, then economic growth and inflation should pick up, and if it is falling, then a downturn in those data sets is likely.
Lower rates boost the velocity of money so the repayments made on mortgages and personal loans falls, leaving consumers with more cash in their pockets to spend on non-essential items, increasing the level of demand in the economy.
If the cash was going to a financial institution as part of a debt repayment, it would take longer to feed back into the real economy, so it would have a slower velocity of money.
Secondly, the base rate falling means banks receive lower interest on the cash they have on deposit with the central bank, or from the government bonds they own.
This encourages banks to lend more into the economy, boosting demand.
Money lent out to people who want to spend it immediately, such as a house or car purchase, has a much quicker velocity than cash left sitting in a metaphorical bank vault.
Two members of the Bank of England’s Monetary Policy Committee (MPC) were guided by the hand of history on January 30, and voted to cut rates.
They were outvoted by the seven colleagues who chose to keep the base rate unchanged at 0.75 per cent.
The reasons for the other seven members voting to hold rates were revealed in the minutes of the latest MPC meeting, which were published alongside the interest rate decision.
The motives ranged from the prosaic, with central bank officials noting that other countries have already cut rates, to the subtler.
These include the increased level of certainty around the political outlook in the UK may boost consumer and business confidence.
For while the velocity of money is heavily influenced by the supply of money, as in the examples cited above, the second factor which determines it, is the demand for money.
This means, there is no point in cutting rates if consumers choose not to borrow what the bank is now willing to lend them, or if they respond to lower mortgage repayment costs by simply saving the cash for a rainy day.
The fund manager Bruce Stout, describes the fondness of some economists for simply focusing on the supply of money in the system, and not the demand for money as “you can take a horse to water, but you cannot make it drink.”