The Bank doesn’t set interest rates
The government handed interest rate decisions to the Bank of England in 1997. Unfortunately the Bank handed rate decisions to the market many years before.
That’s why the Bank keeps reducing rates and why borrowers are not seeing the benefits. The cut announcements are a bold gesture and a clear indication of the central bank’s wishes – and probably, despite its independence, of the government’s desires too – but it does not change the cost of money in the marketplace.
The Bank no more sets interest rates than the stock exchange sets share prices. They both reflect the price at which demand equals supply, and just as a clever market-maker could anticipate that equilibrium point when quoting stock prices, the Bank can often be just ahead of the curve and set interest rates at the level they are heading for anyway.
For a long period, therefore, it looked at though the Bank set rates because it moved them just before the market moved.
But in recent months the Bank’s hopes and the market’s expectations have become incompatible. Libor, the interbank rate that balances supply and demand, has been upto 100 basis points above the base rate set by the Bank.
And that’s before lenders increase their margin over Libor to cover the greater perceived risk.
If central banks could bring down the cost of borrowing they would slash rates at the first whiff of recession – even if they had not slashed them anyway. They cannot. While a cartel like Opec can influence the price of oil by controlling supply, central banks do not control the supply of money.
It requires willing lenders to increase the supply to cut the cost of borrowing – as happened throughout the final decade of the boom. Now they have burned their fingers they are reluctant to lend, so the price is high.
The cuts by the Bank of England generate big headlines and make a policy statement but they make little difference to the cost of borrowing. The only difference between the Bank setting an irrelevant base rate and ministers doing it is to remove some of the politics.
November 5th, 2008 at 6:31 pm
Good post, absolutely spot on regarding the interest rate scenario, but none the less we still manage to get excited this time every month. Interesting that MP’s seem to be gaining a majority on financial institutions passing on any rate cuts to lenders, when as you quite clearly say, nothing really changes at all.