Is cutting interest rates a good idea?

It has been a hell of a long time since my last post! I have been off enjoying myself in Vegas before the Xmas break and Mauritius post New Year. The economic, financial and political world gone through a great deal since my last post - the inauguration of Obama in the US, more government bailout's on the cards, terrible unemployment (Q4 2008 1.92m, highest level since 1997) and GDP (Q4 2008 -1.5%, official recession confirmed by 2 consecutive quarters of negative growth) figures confirming the recession is with us, the Israel-Gaza conflict, just to name a few.

The latest piece of news announced today is that the BoE base rate has been cut by 50bps to a record low of 1% - the 5th interest rate cut since October. The aim is obvious - to attempt to stimulate lending and to boost the shrinking economy. Good news for industrialists, retailers, builders and estate agents. However, as I have written about previously, I completely disagree with the notion that we should try to borrow our way out of trouble, hence I think the rate cut is yet another wild decision by the powers that be.

Firstly, it is terrible news for savers and creates moral hazard. Those who were prudent enough to save when things were booming no longer have the same incentive especially when they see bail outs for the careless being handed out left, right and centre. It is as if they want people to get themselves into more debt that they can't pay off rather than save which is what caused this crash in the first place! What the BoE seem not to understand is that by paying lower rates there is less of a chance that people will keep their cash in the bank or building society. The result, fewer funds become available for borrowers and the effect of the interest rate cut is nullified.

Secondly, the damage to sterling could be horrendous. Lower rates means lower returns for foreign investors in sterling denominated products. That gives them less of an incentive to hold sterling, lowering it's value. The more the pound devalues, the more reluctant external holders are to own it. The implications are that in order to service the massive national debt which is estimated to be well over £1 trillion within 5 years, the government will have to issue hundred of billions of pounds worth of gilts. And if external investors do not want to invest in sterling assets, who will buy the gilts?! Unless the government offer higher rates to entice investors - so by cutting the base rate, the long term rate of interest that we'll have to shell out is forced up.

A look back at recent history points to the Japanese interest rate cut to nearly zero in 1995. All that succeeded in doing was shattering confidence so badly that the economy suffered the so-called “lost decade” of collapsing property and share prices. In fact, the Nikkei 225 index is now no higher than it was fully 26 years ago. The bottom line? Lowering interest rates from 5.5% made sense. Cutting them now is a big mistake. Unfortunately, the Bank of England has struggled to work that out.