The thing about useful stuff is: Enough to make you scream

Enough to make you scream Wednesday, October 08, 2008

UK - London - The City: Bank of England and Fi...

Image by wallyg via FlickrThe growing clamour for interest rates to be cut rather misses the point.

The Bank of England can set the Bank Base Rate i.e. the rate at which it will transact with banks. However, the rate at which banks lend to each other is higher than this to reflect the additional risk (know as LIBOR rate). Presently the differential between the base rate and LIBOR is approaching several hundred basis points (100 basis points = 1%) rather than the usual handful of basis points.

Yet banks are refusing to lend to each other regardless of the "price", other than overnight, because of the perceived risks and uncertainty overshadowing counterparties - reducing rates in such circumstances doesn't remedy that.

At the same time as not lending to each other, banks are not lending to corporates or individuals because in the current climate they are hoarding cash to meet immediate and future claims on them by savers/depositors.

For savers, safety has become of paramount importance more so than the rate paid - previously savers "assumed" banks were all reasonably safe and hunted round for the highest rates e.g. depositing funds with Icesave. Now, regardless of the rate offered they are unwilling to deposit funds with institutions they consider "shaky", which in turn chokes off the supply of funds that can be lent.

A shortage of funds available to lend results in rationing and price ("rates") is the mechanism for this. A shortage pushes prices up and not down.

Unfortunately the public's understanding remains linked to a past [4 weeks ago or more] when credit was in abundance and you simply needed to reduce interest rates to stimulate the economy and turn the credit taps on. Hopefully, you are better informed.