Sub Zero?

Yesterday the Bank of England cut rates by 0.5% to the new record low of 1%. The problem that the BoE now faces is that it’s reaching the end of its effective use of traditional policy. Theoretically rates could be set below zero at a negative rate, by charging banks to deposit their cash. However, faced with a negative rate on savings, banks and individuals would simply invest in a safe, and store their cash at no cost. To overcome this the BoE could (again, in theory) create bank notes that fall in value, or expire as legal tender on a set date. Theoretically possible, practically impossible.

So, if the appropriate policy rate is -1% rather than +1%, what can the BoE do? Firstly, if it thinks a negative rate is required the best it can do is cut rates quickly (which it has), and get them to the limits of its policy bands (lets say 0%.) Secondly, as it isn’t able to generate an appropriately negative rate for a short period of time to shock the economy and inflation back into life, it will have to compromise, by keeping rates low for longer. Not the perfect policy response, but the best it can do.

If the market doesn’t believe that the bank rate is going to be held low for longer, then the bank can work with the authorities to drive rates lower along the yield curve. It can do this by intervening in the money and government bond markets, thus providing a low risk free rate benchmark for months, and maybe years.

The next problem the bank faces is setting the real economy market rate that banks, corporates and individuals will actually lend to each other at (ie the non risk free rate). The BoE recognises that traditional policy isn’t working, and is proposing to act as a buyer of, for example corporate debt (see my blog from last month), while the government has provided equity and credit insurance to enable banks to borrow in these difficult real world conditions. These measures combined are being proposed to limit the damage caused by the credit crunch. If they work, fine. If not, more of the above will be attempted, and UK base rates will stay very very low, for very very long.