Behind the Bank of England’s Base Rate Cut
by Gary Dorsch, Global Money Trends. December 6, 2007
The Bank of England cut interest rates by a quarter-point to 5.5% to cap a rise in sterling Libor rates, and ease credit conditions for UK households and businesses. "Higher energy and food prices are expected to keep inflation above target in the short-term. Although, upside risks to inflation remain, which the BoE will continue to monitor carefully, slowing demand should ease the pressures on supply capacity, bringing inflation back to target in the medium-term."
Apparently, the BoE has little tolerance for pain and panicked when UK house prices fell 1.1% to 194,895 pounds ($400,000) in November, the first time home prices fell for three months in a row in 1995. According to the chart above, the BoE is an asset targeter, adjusting its base rate in tandem with trends in UK home prices. The BoE's aggressive rate cutting campaign in 2001 ignited a doubling of UK home prices through mid-2007, prompting the central bank to reverse course by hiking its base rate from a low of 3.50% in 2003 to as high as 5.75% in July this year.
The last five BoE rate hikes from 4.50% to 5.75% was a belated effort to rein in the growth of the British M4 money supply, which had crossed into double digit territory in 2005 to a record high of 13.8% in May 2006. The BoE was able to finally rein in the growth of M4 with its last two rate hikes, slowing the M4 supply to 11.8% growth in October, but still at double-digit rates that stokes higher inflation.
A further slowdown in the UK M4 money supply to single digits is the BoE's line in the sand and seen as too risky, especially at a time when the Bernanke Fed is expanding the US M3 money supply at a 15.8% annualized clip, its fastest in history, with deeper Fed rate cuts ahead. A too tight BoE money policy could have catapulted the British pound above its 23-year high of $2.11 and hurt exporters at a time when the UK trade deficit hit a record 7.75 billion pounds in October. Instead, the BoE opted for the "Bernanke Put" – rate cuts and currency devaluation.
The other big threat to the UK economy is the credit crunch in the Sterling Libor market in London, where 3-month yields jumped to 6.65%, or 90 basis points above the BoE's base rate. Normally, the three-month Libor rate trades at a small premium of around 0.15% above where the market thinks the Bank of England's base rate will be in three months' time. But since the shocking revelations of the sub-prime mortgage debt crisis came to the surface in mid-July, with potential losses to global banks of anywhere from $250 billion to up to $1 trillion, Euro Sterling rates have shot much higher to as high as 100 basis points above the BoE's base rate.
Higher Sterling Libor rates threaten put upward pressure on British mortgage rates, threatening home prices, and rattling consumer wealth and confidence. BoE chief Mervyn King said a further drop in asset prices "might impair the balance sheets of the banking system in the US, which would lead to a classic credit squeeze. Although that fear has so far run well ahead of realized losses, it has the potential to lead to a further tightening in credit conditions," said King. The BoE is choosing to throw money at the problem by lowering its lending rates after it injected 10 billion pounds into the banking system on Nov 30th.
© 2007 Gary Dorsch