The Bank of England reduces rates! Why this will have no impact.

People assume that the Bank of England sets interest rates and are confused that any rate cuts are not immediately passed on by the banks. A brief explanation is needed.

First of all the Bank of England (BoE) is the only institution in the UK that can print sterling. The interest rate is sets is the rate at which the BoE is prepared to lend overnight to a select list of institutions. The BoE’s activities in the money markets (those markets where banks borrow and lend to each other) seek to move the money market rates towards the BoE’s interest rate.

The BoE will provide liquidity to the money markets. Banks have to balance their cash every day and if they are short, having been unable to borrow from the money markets, then they need to borrow from the BoE. The BoE does this at the prevailing BoE interest rate.

Why would this encourage the banks to reduce their mortgage rates and other lending rates? Theoretically the BoEs overnight rate, the rate reduced today to 3%, will force the short-term money market rates down to this level. If the money market overnight rate falls then part of the banks funding costs fall. Now, because banks make their money by borrowing short (from depositors and money markets) and lending long (to companies and through mortgages), a reduction in the short-term rates should reduce their costs and lead to a reduction in their loan rates.

I say “should” – well in a competitive market with low costs of change for borrowers this would tend to be true. Today this is not true. Consumers can’t change mortgages except with great difficulty and the costs for companies of changing loan providers has always been high.

The result is that the BoE is impotent. A reduction to 0% would hardly have been any better.

The real problem is that, as I have mentioned previously, a partial privatisation is a nonsense. It’s either all or nothing.

This Governmant has financed the banks to rebuild their profits with no upside for the Government and allt he upside for the shareholders. This is a disgraceful misjudgement.

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