Archive for November 6th, 2008

BoE cuts rates by 150 bps!

November 6, 2008

Well, this is the biggest of all. BoE cuts rates by 150 bps to 3.00%. The growth situation looks too bad:

In the United Kingdom, output fell sharply in the third quarter. Business surveys and reports by the Bank’s regional Agents point to continued severe contraction in the near term. Consumer spending has faltered in the face of a squeeze on household budgets and tighter credit. Residential investment has fallen sharply and the prospects for business investment have weakened. Economic conditions have also deteriorated in the UK’s main export markets.

Inflation has disappeared:

In recent weeks, the risks to inflation have shifted decisively to the downside. As a consequence, the Committee has revised down its projected outlook for inflation which, at prevailing market interest rates, contains a substantial risk of undershooting the inflation target. At its November meeting, the Committee therefore judged that a significant reduction in Bank Rate was necessary now in order to meet the 2% target for CPI inflation in the medium term, and accordingly lowered Bank Rate by 1.5 percentage points to 3.0%.

Wondering what ECB will do as it meets today as well.

Monetary Policy Transmission channels and role of Central bank

November 6, 2008

I had earlier expressed concern over ongoing frequent and dramatic rate cuts by central banks world over (exceptions are Denmark and Iceland). The latest in cutting is Australia by 75 bps (it cut by 100 bps in September 2008!). However, I don’t understand how such dramatic rate cutting will help when things are frozen? A rate cut can only lower the cost but right now people are not willing to lend/borrow and a central banks can’t as people to start to lend/borrow. However, Central bankers have different ideas.

I came across 2 speeches from Bank of England MPC members, both differing on this monetary transmission channel. UK MPC member Tim Biesley  in his speech says:

Right now, all three of the conventional channels for the transmission of cuts in Bank Rate on to the real economy are impaired. I have already discussed the context for consumers where credit availability and an adjustment in the savings ratio are the real story.
Monetary policy also has an effect on financial conditions faced by businesses, who frequently borrow using products that are linked to Libor. As we noted above, the 3-month Libor remains well above Bank Rate. …The MPC’s ability to influence this by changing Bank Rate is limited while the interbank market continues to function imperfectly. For example, between 8 October, the day of the coordinated 50 basis points interest rate cut, and 9 October, the level of the 3-month Libor rate increased by 1 basis point in the UK money market.
The third channel of monetary policy transmission works via the exchange rate. Even in normal times, uncovered interest parity has proved to be a generally poor guide to exchange rate movements. At the present time, movements in Sterling appear likely to remain more influenced by an assessment of general economic prospects in the UK and the risk premium that investors are demanding to hold Sterling assets, rather than with the level of Bank Rate.

So, Biesley is not very hopeful that interest rate cuts alone will work:

A cut in Bank Rate, on its own, will not be a magic bullet. No single instrument can work to achieve all goals.

In another speech, David Blanchflower says:

In my last speech given to the David Hume Institute in Edinburgh on 29 April 2008, I argued that more had to be done to prevent the UK entering recession and the MPC needed to be more aggressive in cutting interest rates. That still remains my view.

The UK is obviously especially exposed to the financial turmoil because of our dependency on the financial sector, and because the run-up in house prices and debt levels was even greater here than in the United States. My view remains that interest  rates do need to come down significantly – and quickly. If rates are not cut aggressively we do face the prospect of a relatively deep and long-lasting recession.

Hmm, quite contrasting views. I also compared the votes of these two members in MPC meeting since Jan-2008. Here are the results:

MPC Blanchflower Biesley Actual outcome Bank Rate
Jan 25 bps cut maintain at 5.5 maintain at 5.5 5.5
Feb 50 bps cut cut by 25 bps cut by 25 bps 5.25
Mar 25 bps cut maintain at 5.25 maintain at 5.25 5.25
Apr 50 bps cut maintain cut by 25 bps to 5% 5
May 25 bps cut maintain maintain 5
Jun 25 bps cut maintain maintain 5
Jul 25 bps cut increase by 25 bps maintain 5
Aug 25 bps cut increase by 25 bps maintain 5
Sep 50 bps cut maintain maintain 5
Oct     global rate cut 4.5

The viewpoints made above are seen pretty strongly in the table. Blanchflower has always voted for rate cuts and Biesley for maintaining or increasing rates. Atleast it is not a case of saying something else and doing something else.

However what Blanchflower says for econopmic research is pretty interesting:

What was the role of economists in all of this? In the US, where I live, economists such as Bob Shiller, Nouriel Roubini, Marty Feldstein and Larry Summers, among  many commentators who anticipated the difficulties the UK economy now faces, despite the similarities with the US experience.

Academic economists seem to have been too busy publishing theoretical  papers rather than looking at data and solving some of the greatest economic policy issues of our age. Difficulties arise when a subject emphasises theory over empirics. Theory is fine but we need to test it against data from the real world to see if it is actually true rather than just elegant.

Read Larry Summers quote he points as well (page 17). Then he says what has always bothered me:

The key economic policy issue over the last decade has been the unsustainable rise in asset and equity prices and associated credit boom. But too often this boom has been dismissed with the mantra that ‘



Central Bank and monetary policy have a lot of thinking to do. Dr. Reddy former RBI Governor put it up nicely:

An outcome of the crisis, according to Dr Reddy, is the “historically significant redefining of the concept of the central bank”.

financial markets price assets efficiently’. It seems less obvious than it did even a year ago that monetary policy designed around the monetary framework of the Bundesbank in the 1970s is that appropriate for an entirely different set of circumstances in the 2000s.



Assorted Links

November 6, 2008

1. WSJ Blog points ADP report shows employment situation is really bad in US

2. Posen is doubtful about deflation

3. FIn Prof points Fed should be only for price stability

4. Crisistalk on shortselling

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