UK: 40pc chance of a rate cut? Really?

A 40pc chance of a rate cut? Really?

By Edmund Conway Economics Last updated: September 9th, 2009

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About a month ago, in a throw-away comment at an economic conference, Charles Goodhart, a former member of the Bank of England’s Monetary Policy Committee unwittingly caused a stir in the money markets. As I wrote at the time, he raised the idea of the Bank imposing a negative interest rate, in other words charging a fee, on the cash Britain’s leading banks keep in store at the BoE itself.

The idea has snowballed, to the extent that in the run up to tomorrow’s MPC meeting, the odds on the Bank cutting its rate are, according to market participants, about 40pc. So might tomorrow mark the onset of negative interest rates for the first time in the UK? I am sceptical.

First, let’s examine the problem. The Bank is trying to get the economy going by pumping £175bn into it through quantitative easing. What this actually means is creating money (yes, printing it - electronically) and using this to buy bonds - almost exclusively government bonds (gilts) - off private investors. The upshot is that as that money goes into the system it finds its way pretty quickly to banks’ balance sheets (either because they sell the Bank the gilts or because pension funds pocket the proceeds and put them in their bank accounts).
Banks tend to keep a good deal of their cash in their own equivalent of a current account - reserves at the Bank of

England. So the upshot of quantitative easing has been to lift the amount sitting in reserves at the Bank to unprecedented highs - up from below £10bn to £142bn at the last count, in August. At the moment, the Bank pays banks a 0.5pc interest rate on this “current account” cash - the same as the BoE bank rate.
The problem is that much of this money is sitting dormant in the banks’ reserves rather than being used to lend to businesses, where it will actually help fertilise UK economic growth. This is the problem the Japanese faced in the 1990s and early 2000s when they first experimented with QE.

Anyway, Prof Goodhart’s suggestion was that the Bank should charge banks to keep this cash with them, rather than giving them 0.5pc interest. This is something the Riksbank in Sweden is experimenting with. The result would not necessarily be that reserves would fall throughout the system as a whole, but the cash would at least be sloshed around the system a little more (velocity is the technical term here) in the form of lending to businesses and companies.

It was an interesting suggestion - interesting enough for BoE Governor Mervyn King to say this at the Inflation Report press conference last month:

It is certainly true that it would be useful to think about ways to encourage banks individually to try to convert some of their reserves into say shorter term gilt holdings or purchases of other assets which would then reinforce the transmission mechanism of the direct assets purchases that we make. And in normal circumstances you might expect that to have some impact. And there is no doubt that the interest rate that we pay on reserves does affect the incentives which banks face to turn those reserves bank by bank individually into other assets. And it’s an idea we will certainly be looking at to see whether in fact the effectiveness of our asset purchases could be increased by reducing the rate at which we remunerate reserves.

Hence the fact that the market is all of a flutter about the prospects that the Bank would do so at this month’s meeting. However, there are some things people have overlooked. The first is that cutting the rate paid on reserves to banks from, say, 0.5pc to 0pc, would be an overall interest rate cut in all but name. It would push down the overnight rate in money markets to close to zero, which in turn would cut borrowing costs across the wider economy (though it wouldn’t affect tracker mortgages etc). So if you’re cutting the rate paid on reserves, why not cut the Bank rate? It is a prospect that is not beyond the realms of possibility tomorrow, though the Bank did make it pretty clear back in March that it viewed 0.5pc as “effective zero” for rates: below that level weird and not so wonderful things would happen in financial markets; certain businesses could malfunction. Think of it as the “millennium bug” effect for financial markets.

Should the Bank be unwilling effectively to cut Bank rate, it could still charge a fee to banks on a proportion of their reserves, allowing them to keep a certain amount (say, in comparison with the size of their balance sheet) but levying a penalty on any extra cash in their coffers. This is pretty close to what Goodhart was suggesting and is a feasible option tomorrow. But I wouldn’t put a 40pc chance on it.

My scepticism stems from a couple of key points. First, there are some early signs that QE is working even without such assistance. The amount of cash flowing around the wider economy - beyond reserves - is starting to pick up. Second, such a move would effectively amount to a tax on the banking sector as a whole. Third, it would also mean tearing up the complex set of rules and regulations that frame Britain’s monetary system once again.

Fourth, and perhaps most importantly, people seem to have forgotten that at the last MPC meeting something unusual happened: Mervyn King was outvoted. The Governor wanted the QE total to reach £200bn rather than the £175bn the MPC eventually opted for. In other occasions when he was outvoted, King usually attempts to get his way in a subsequent meeting. So might it not be more likely that the Bank will opt for a little more in the way of QE?

Perhaps, perhaps not. The fact is that market participants, having been surprised by the Bank’s decisions again and again in recent months, are suffering a slight degree of paranoia these days. Having been burnt more than once, they are putting greater odds on a surprise decision than they really ought to be. This is a tougher meeting to call than last month’s (to my mind at least, though the markets misjudged that one). And that’s for good reason: the economy is showing at least some signs of recovery - though this does not rule out a further relapse next year, something I’ve written about a number of times. This may well be one of those meetings when the MPC judges it best simply to do as little as possible. A boring MPC meeting? Never thought I’d see the day that one of those would be the exception rather than the norm.

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