Bank cuts rates again - and starts getting radical

Interest rates are cut to 0.5%, as the Bank of England frees up £75bn to boost the money supply...

Last Updated: 31 Aug 2010

In addition to slashing the base rate to 0.5%, down from 1%, the Bank of England’s Monetary Policy Committee also announced its long-awaited ‘quantitative easing’ plan – it’s going to buy £75bn of private and public sector assets from its own reserves to try and get more money circulating in the economy. It’s the first time the Bank has ever gone down this route – so the only problem is that nobody appears to have any idea whether it will work…

Today’s rate cut, the sixth since October, was pretty much in line with expectations. As the Bank said today, UK output slid by 1.5% in the last quarter of 2008, thanks partly to ‘the persistent problems in international credit markets’. Unemployment is rising, the housing market’s in the doldrums – and with falling commodity prices and the VAT cut pushing down household bills, CPI inflation is likely to under-shoot the Bank’s 2% target later this year. So ‘on balance’, the MPC decided a cut was a good idea.

But it sounds like the decision wasn’t entirely straightforward (it’ll be interesting to see how tight the vote was) – and not just because of the unfairly invidious impact on savers. Some economists have argued that reducing the cost of borrowing again would only bite into banks’ profit margins, while further undermining the pound (that’s bad for the government, because it increases the cost of its debts). Equally, others suggested it was pointless, because the cuts weren’t having any impact anyway.

Clearly the Bank was sympathetic to these points, because it’s also taking action to boost the money supply. Although it’s not literally printing money, it basically amounts to the same thing: it’s been authorised by the Chancellor to free up £75bn of newly-created virtual funds (possibly rising to £150bn) to buy corporate and Government bonds over the next three months. Once these have been credited to the relevant accounts, the theory is that there'll be more money swilling round the system, and the banks will end up with some extra cash that they can lend to the rest of us.

Or of course, they might just sit on the extra cash and use it to repair their battered balance sheets. And therein lies the problem: because this policy has never been tried before, nobody really knows whether it’ll work – and even if it does, we can only guess how much money it will require and how long it will take. So the Bank will monitor progress over the next few months, trying to work out where best to spend its money. 'Suck it and see’, basically...

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