Friday, May 9, 2008

Why Bank Kept Interest Rates Unchanged

Despite falling house prices and the prospect of a slowdown in the economy, the Bank of England kept interest rates unchanged at 5% this May. The main reason for this is:

They are worried about inflation. In particular the rising price of oil and food is causing cost push inflationary factors. Even the CPI (which excludes many housing costs) is getting close to the 3% limit set by the Chancellor. The MPC would be embarrassed to cut rates and then in the same month see inflation rise above the target.

They hope the slowdown may not be as bad as feared. On backward looking statistics such as unemployment and economy growth the economy appears to be doing relatively well; there is no need for panic just yet.

They have cut rates 3 times and this may just be a pause before the next cut in June. If they cut rates too quickly it may give the impression of panic and this may unsettle the markets or at least increase inflation expectations.

Nevertheless with no let up in the shortage of mortgage finance, the situation is only likely to get worse; it may be that in an era of rising inflationary pressure, the government's target of 1-3% could be an unattainable goal and the Government may have to consider changing the inflation target to reflect a deterioration in economic conditions.

The MPC's approach contrasts strongly with that of the Fed. Faced with a housing crash and slowdown in the economy, the Fed cut rates to 2% and the government introduced a tax rebate to stimulate the economy. The American economic situation was less favourable, but, it also shows a willingness to be bolder in staving off a recession and worry less over inflation.

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