OpinionJan 30 2020

Why the Bank of England left interest rates unchanged

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Why the Bank of England left interest rates unchanged
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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. 

Money lent out to people who want to spend it immediately has a much quicker velocity than cash left sitting in a metaphorical bank vault

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.” 

The likelihood of a consumer spending the extra cash they are supplied with as a result of a rate cut is dependent on their level of confidence.

The uncertainty of a general election and the Brexit process in 2019 dented confidence, which was negative for most of last year.

Negative consumer confidence implies individuals were choosing not to spend or borrow more, at the present interest rate, so if consumers view recent political developments as providing greater certainty, then they are more likely to increase spending, without rates needing to be cut. 

In the Bank of England minutes, this scenario was explained as follows: “Domestically, near-term uncertainties facing businesses and households have receded.

"Surveys of business activity have picked up, quite markedly in some cases, and investment intentions appear to have recovered.

"Housing market indicators have strengthened and consumer confidence has increased slightly.

"The Committee will monitor closely the extent to which these early indications of an improved outlook are sustained and follow through to the hard data on domestic activity in coming months.”

If this happens there is then no need to lower rates to achieve economic growth.

But while there may be no need to cut interest rates, if the economy is starting to grow, and this would be viewed as a positive, the central bank also pointed to negative connotations. 

Cutting interest rates only boosts economic growth if there is unused capacity in the economy.

If the economy is already growing at its full potential, then a rate cut boosting demand simply leads to higher inflation, and potentially lots of cash being deployed in speculative ways, creating a bubble in the economy such as that which happened before the global financial crisis when the extra debt in the system was deployed into property assets. 

The Bank of England’s chief economist Andy Haldane previously told the Treasury Select Committee of the House of Commons that as a result of lower immigration and higher barriers to trade due to Brexit, the level at which the UK economy has reached its full growth potential has fallen from 2 per cent to 1.5 per cent.

This means cutting rates if growth is 1.5 per cent or higher would lead to higher inflation, not higher growth. 

In the minutes of the meeting today, the central bank said it now feels the potential growth rate for the UK economy over the next three years is just 1.1 per cent, meaning that any interest rate cut if growth is at, or above, that level, would simply add inflation, not growth, meaning there is no need to put rates up.  

david.thorpe@ft.com

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