Thursday, October 23, 2008

How Much Should Interest Rates Fall?

Readers Question: In recession it is good to cut interest rate, but to how far should interest rate be cut? What are the disadvantages of cutting interest rate?

It's a good question, and the MPC will be having a big debate amongst themselves how much interest rates should fall. For the past year, David Blanchflower has been arguing interest rates are too high and need to come down more quickly. However, his other colleagues were more cautious, so interest rates have fallen only slowly this year. In the US, interest rates have fallen much more quickly to 2%

Lower interest rates help the economy to recover from recession because:
  1. Reduces mortgage payments, increasing disposable income. (Just yesterday I had a letter from Standard Life, saying my interest only mortgage will fall from £627 to £570 a month - I will definitely be spending more!)
  2. Cheaper to Borrow for investment
  3. Less incentive to save, more incentive to spend.
  4. Reduces value of Pound, which makes exports cheaper and helps increase aggregate demand.
With economic prospects plunging, unemployment rising and manufacturing output falling, there are some people arguing that rates should fall to 2% soon.

What are the disadvantages of Interest rate cuts? - Why are Interest rates not 2% already?

1. Inflation. Lower interest rates typically boost spending and cause inflation. It is the prospect of more inflation which make the MPC reluctant to cut rates. Unfortunately, this year we have seen a rise in inflation to over 5%. This is because of cost push factors, such as rising oil and electricity prices. The MPC have an inflation target of 2%, so in theory normally, they would be considering increasing rates. However, with unemployment approaching 2 million, inflation doesn't seem very important in comparison. Also there is a hope that this inflation will prove only temporary and next year inflation will fall sharply.

2. Savers Lose Out. Interest rate cuts are great for people like me with large debts. But, interest rate cuts are not good for pensioners who live off interest on savings. At the moment, inflation is higher than base rates. Therefore, many savers may see a decline in the real value of their savings. Cutting interest rates to 2% would make them worse off, especially if inflation persists. Savers are often pensioners.

3. More Expensive Imports. Since interest rates have fallen, the value of the £ has fallen. This is due to less 'hot money flows' people wanting to save in the UK. Because the value of the Pound is lower, imports become more expensive. This reduces our living standards and can contribute to imported inflation. (though lower exchange rate is good for exporters)

4. Lower Interest rates may not work. This is a kind of disadvantage. Lower interest rates may not avoid recession. Lower interest rates may not help because:
  • Banks don't want to lend. Therefore, even though borrowing costs are cheap, the finance isn't there because of the credit crunch.
  • Banks may not pass the base rate cut onto consumers
  • Confidence is low therefore people don't spend any more, even though mortgages are cheaper. (e.g. liquidity trap that Japan faced in the 1990s.)

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