Rational Economic Woman (or Man) and Bank of England Base Rates

Something really rather odd may be about to happen on Thursday 3rd August (or, if you are reading this after that date has happened or was expected to happen!).

 

I am writing this on 1st August and so am making myself a hostage to fortune somewhat by considering a future event which may or may not happen. The event I am referring to is the next meeting of the BofE Monetary Policy Committee and its decisions regarding the BofE base rate.

 

It is currently at 0.5% and has been since 05 March 2009…..I know.  For more than 7 years (!) we have been at what was originally described by some as an ’emergency rate’ to assist in the quick repair of our economy and a return to normality (or ‘normalcy’ if you are a fan of early 20th century American political history. A ‘Return to Normalcy’ was the campaign slogan of Warren Harding in the 1920 Presidential race).

 

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Those prospects for a ‘repair’ of the UK economy and a return to normality have, apparently, taken a turn for the worst. Whether this is because of the referendum decision on 23rd June, or whether what we are now experiencing is the ‘new normal’ are not the concerns of this particular blog piece.

 

What it is concerned with are the rumours circulating in the business press are that the MPC will cut the base rate. In some parts of the world, negative base rates have been tried –  ie it costs banks money to lodge their cash with the BofE. I would be surprised if the base rate move in the UK was of such magnitude that it went negative –  I know, It only has to drop 0.75% to become negative, which isn’t a huge reduction from +0.5%, but to go negative in the first place is of enormous psychological significance.

 

Let us assume that the base rate does fall, but that the BofE still wants to retain some semblance of ‘wriggle room’ for the future. In which case, it will reduce to 0.25%. The theoretically pure explanation of such a move is that it lowers the cost of borrowing which will have the effect of making finance (principally debt) to investors and consumers cheaper. Cheaper costs of funds mean that more investment projects become financially viable than was the case and / or make it less costly to borrow to fund purchase for consumers. So goes the logic.

 

Whilst this makes perfectly logical sense it only does so because it rests on a huge assumption: that businesses and consumers alike (i.e. people) operate as coolly rational calculators. Hence any fall in the cost of funds, no matter how slight, will lead to several (or possibly a whole raft) of economic decisions regarding, say, investment in productive capacity (which is really just another way of saying buying kit and equipment) by a business now making ‘economic sense’. Similarly, with consumers, a fall in interest rates makes saving less attractive and consumption (if debt financed) cheaper. So they (i.e. you and me) go out and spend and the economy receives, potentially, something of a shot in the arm.

 

So goes the theory.

 

Whilst there may be some mileage in this view of investment and consumption behaviour, do we really think that lowering the cost of £100 of debt by some 25p per annum is really going to have a hugely beneficial impact on the economy? Might it, in fact, have the opposite effect? Might we all regard any rate cut as a sign that the economic prospects for the UK are worse –  and if so, perhaps now is not the time to be taking on more debt to fund either investment or consumption?

 

Time will tell…..

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