I had earlier expressed concern over ongoing frequent and dramatic rate cuts by central banks world over (exceptions are Denmark and Iceland). The latest in cutting is Australia by 75 bps (it cut by 100 bps in September 2008!). However, I don’t understand how such dramatic rate cutting will help when things are frozen? A rate cut can only lower the cost but right now people are not willing to lend/borrow and a central banks can’t as people to start to lend/borrow. However, Central bankers have different ideas.
I came across 2 speeches from Bank of England MPC members, both differing on this monetary transmission channel. UK MPC member Tim Biesley in his speech says:
Right now, all three of the conventional channels for the transmission of cuts in Bank Rate on to the real economy are impaired. I have already discussed the context for consumers where credit availability and an adjustment in the savings ratio are the real story.
Monetary policy also has an effect on financial conditions faced by businesses, who frequently borrow using products that are linked to Libor. As we noted above, the 3-month Libor remains well above Bank Rate. …The MPC’s ability to influence this by changing Bank Rate is limited while the interbank market continues to function imperfectly. For example, between 8 October, the day of the coordinated 50 basis points interest rate cut, and 9 October, the level of the 3-month Libor rate increased by 1 basis point in the UK money market.
The third channel of monetary policy transmission works via the exchange rate. Even in normal times, uncovered interest parity has proved to be a generally poor guide to exchange rate movements. At the present time, movements in Sterling appear likely to remain more influenced by an assessment of general economic prospects in the UK and the risk premium that investors are demanding to hold Sterling assets, rather than with the level of Bank Rate.
So, Biesley is not very hopeful that interest rate cuts alone will work:
A cut in Bank Rate, on its own, will not be a magic bullet. No single instrument can work to achieve all goals.
In another speech, David Blanchflower says:
In my last speech given to the David Hume Institute in Edinburgh on 29 April 2008, I argued that more had to be done to prevent the UK entering recession and the MPC needed to be more aggressive in cutting interest rates. That still remains my view.
The UK is obviously especially exposed to the financial turmoil because of our dependency on the financial sector, and because the run-up in house prices and debt levels was even greater here than in the United States. My view remains that interest rates do need to come down significantly – and quickly. If rates are not cut aggressively we do face the prospect of a relatively deep and long-lasting recession.
Hmm, quite contrasting views. I also compared the votes of these two members in MPC meeting since Jan-2008. Here are the results:
| MPC |
Blanchflower |
Biesley |
Actual outcome |
Bank Rate |
| Jan |
25 bps cut |
maintain at 5.5 |
maintain at 5.5 |
5.5 |
| Feb |
50 bps cut |
cut by 25 bps |
cut by 25 bps |
5.25 |
| Mar |
25 bps cut |
maintain at 5.25 |
maintain at 5.25 |
5.25 |
| Apr |
50 bps cut |
maintain |
cut by 25 bps to 5% |
5 |
| May |
25 bps cut |
maintain |
maintain |
5 |
| Jun |
25 bps cut |
maintain |
maintain |
5 |
| Jul |
25 bps cut |
increase by 25 bps |
maintain |
5 |
| Aug |
25 bps cut |
increase by 25 bps |
maintain |
5 |
| Sep |
50 bps cut |
maintain |
maintain |
5 |
| Oct |
|
|
global rate cut |
4.5 |
The viewpoints made above are seen pretty strongly in the table. Blanchflower has always voted for rate cuts and Biesley for maintaining or increasing rates. Atleast it is not a case of saying something else and doing something else.
However what Blanchflower says for econopmic research is pretty interesting:
What was the role of economists in all of this? In the US, where I live, economists such as Bob Shiller, Nouriel Roubini, Marty Feldstein and Larry Summers, among many commentators who anticipated the difficulties the UK economy now faces, despite the similarities with the US experience.
Academic economists seem to have been too busy publishing theoretical papers rather than looking at data and solving some of the greatest economic policy issues of our age. Difficulties arise when a subject emphasises theory over empirics. Theory is fine but we need to test it against data from the real world to see if it is actually true rather than just elegant.
Read Larry Summers quote he points as well (page 17). Then he says what has always bothered me:
The key economic policy issue over the last decade has been the unsustainable rise in asset and equity prices and associated credit boom. But too often this boom has been dismissed with the mantra that ‘
Central Bank and monetary policy have a lot of thinking to do. Dr. Reddy former RBI Governor put it up nicely:
An outcome of the crisis, according to Dr Reddy, is the “historically significant redefining of the concept of the central bank”.
financial markets price assets efficiently’. It seems less obvious than it did even a year ago that monetary policy designed around the monetary framework of the Bundesbank in the 1970s is that appropriate for an entirely different set of circumstances in the 2000s.
Mostly Economics 
