U.K. central bank does not follow Fed to ZIRP

The U.S. Dollar got more bad news today when the Bank of England (BoE) decided to not follow the U.S. Federal Reserve’s lead to a Zero Interest Rate Policy (ZIRP). The BoE was seen as the most likely to follow in the Fed’s footsteps as i suffers from the same debilitating economic problems a popped housing bubble and record writedowns followed by job losses, a lack of consumption, and economic stagnation. Most importantly, U.K. banks simply are not lending. But that does not mean they want to follow the U.S. to zero.

Bank of England policy makers voted unanimously to cut the benchmark interest rate to 2 percent this month and refrained from a bigger reduction on concern it may prompt about an “excessive” drop in the pound.

The Monetary Policy Committee, led by Governor Mervyn King, voted 9-0 to bring the rate to the lowest since 1951, minutes of the Dec. 4 decision published in London today show. While the economic outlook had worsened, a cut of more than one point may push the currency down too far and “undermine confidence in the economy more widely,” the minutes said.

The pound dropped to a record low against the euro after data showed unemployment rose in November at the fastest pace since 1991. King has signaled that the bank will cut the interest rate further if needed and the U.S. Federal Reserve yesterday lowered its rate close to zero. You should note that the British Pound has not fallen against the Dollar. Taking rates to zero percent can have bad unintended consequences as Financial Times pointed out yesterday (hat tip Yves Smith).

When rates tumble to low levels, it reduces the economic incentive to lend securities. The reduction in liquidity in the $5,800bn Treasury market comes at a time when conditions have become strained as the calendar year draws to a close.

The problems also come as the US Treasury prepares to issue a massive amount of new government bonds for the current financial year.

“Low rates are having a corrosive effect on the repo market, which will impair liquidity in Treasuries,” said Michael Cloherty, strategist at Banc of America Securities. “We are getting close to a situation where structural damage caused by low interest rates outweighs any benefit from easier monetary policy.

“In a [financial] year where the Treasury is facing a net financing need of roughly $1,800bn, lower trading volume is a major concern.”

Problems in repo impair general trading across the Treasury market. A rise in so-called failed trades, where a borrowed security is not returned in a timely fashion, becomes a drain on the balance sheets of dealers. Low interest rates are also hampering the ability of dealers in financing positions by matching the different needs of clients, known as matching offsetting trades.

“The zero per cent interest rate environment is effectively eliminating the dealer matched-book business and crippling dealer intermediation in the repo market,” said Scott Skyrm, senior vice-president at Newedge, a repo broker dealer.

I am not particularly confident the Federal Reserve will have much success in its experiment with ZIRP or with quantitative easing for that matter. The idea that the Fed should buy up financial assets also leaves me cold. They risk distorting the price signals that free markets give to investors and businesses with all of this market interference.

The Bank of England is correct in not having followed the Fed to zero. Maybe British savers will take some cheer from that decision.

Sources BOE Voted 9-0 for Interest-Rate Cut to 2% in December – Bloomberg Unemployment increases by 137,000 – BBC News Ultra-low US rates undermine repo market – Financial Times

Originally published at Credit Writedowns and reproduced here with the author’s permission.

One Response to "U.K. central bank does not follow Fed to ZIRP"

  1. Sonanos   December 17, 2008 at 2:34 pm

    The UK should put up interest rates thereby speeding up the collapse of venerable companies and over stretched householders. Prices will collapse very quickly and new opportunity to borrow and revitalise the economy will occur. This will happen over 12 months, or the alternative is a long slow, cheating yourself death with an even longer recovery stage. Quick and fast shock will be better psychologically to keep people interested in doing business. A long drawn out process to the same point will even fool some good business people who are needed for the revitalisation, and hence make any future recovery even more difficult. Raise Interest Rates to 7%