Sunday, April 19, 2009

Possible Reasons Bank Of England Put Interest Rates On Hold

The recent move by Bank of England to keep interest rate on hold on 0.5% was widely expected. Rates remain at all time low after 7 consecutive cuts since August last year

Source: BBC
There are several reasons for this:

(1) Realising that interest rate cut is not effective. Probably BOE took a lesson from Federal Reserve. Not even a 0% interest rates can reverse the contraction of economy. The nature of recession in this round is very much different than the previous. It is due to the fact that banks are trying to revitalise their balance sheet & also at the same time there is shortage of credit in the financial market. In short, banks are very much less willing to lend. Therefore, even though cost of borrowing is at attractive level much of the loan application would have to be turned down. Furthermore, there are lag effects & probably the impact won’t be felt, not until at next year

(2) Better alternative tool. It is called quantitative easing. This is a non-traditional monetary tool. It means easing the economy by increasing the quantity of money. How? By buying assets such as corporate & government bonds so that the bank will be flushed with liquidity & therefore can resume lending to companies & individuals as usual. Bank of England grew fond of this measure recently. It is optimistic that this will have an immediate impact. It has announced the creation money to buy £75 billion worth of bonds & will be done in 3 stages

(3) Protect savers. Keen savers have witnessed the return from their savings diminish sharply in recent months. Although the current level of interest rates is very low, some argued that it’s better than nothing. Also any further cut in interest rates will cause failure in attracting deposits. Commercial banks may still be haunted by liquidity problems & the central bank will have to print more money

(4) Wait & see. It could be very difficult to assess the impact onto wider economy if interest rates are continuously slashed. Also the Bank may need to investigate what is the optimal level of interest rate cut before economic activities begin to pick up? Is it 0.5%, 2.0%, 2.5% or 3.0%? Furthermore, by holding the rates on hold enable economists & policymakers to segregate the effect of these two measures

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