Olena Staveley-O’Carroll is an assistant professor of economics at the College of the Holy Cross in Worcester, Mass.
On Thursday, the Bank of England is expected to cut the interest rate from 0.5% to as low as zero. Mark Carney, the Bank’s governor, warned about the deteriorating outlook of the British economy after its voters chose to exit the European Union. The resulting political turmoil, including the upcoming replacement of the Prime Minister David Cameron by Theresa May—who had supported Britain staying in the EU prior to the referendum results—has caused a spike in uncertainly about the future economic stability of the economy. Carney hopes that lower interest rates will bolster flagging consumer and business confidence and boost economic output via higher spending and investment, but the impact is likely to be negligible.
In addition to the expected interest rate cut, the Bank of England relaxed its capital requirements on the banking sector earlier this month in an effort to maintain a steady flow of credit to households and firms; the move is expected to release up to $200 billion (at the current rate of $1.32 per pound) in additional loans to the private sector. However, a more prudent course of action—for both interest rates and capital requirements—would be to wait for the outcome of the exit negotiations between the U.K. and the EU. The effect of monetary policy on the economy is likely to be reduced in times of uncertainty, so cutting interest rates this week may not deliver the desired uptick in spending. Worse, the Bank may find itself needing to deliver yet another boost to the economy in the next several months—especially if the EU restricts free access to its markets for goods and services—but without the conventional means to do so if the interest rate already sits at the zero lower bound.
Still, the fears that easing monetary policy may lead to inflation are premature. Positive rates of inflation are difficult to achieve in the environment of heightened uncertainty, when households and businesses tend to postpone major spending decisions and banks are reluctant to issue new loans. Take, for example, the U.S. experience in the wake of the 2008 financial crisis. Even with the federal funds rate hitting zero at the end of 2008—and despite the three subsequent waves of quantitative easing undertaken by the Federal Reserve Bank—the growth rate of consumer prices has remained below 2% for most of the period since the end of the recession in 2009. Most of the liquidity created by the Fed has been hoarded by the banking sector, reluctant to issue new loans in the midst of ongoing talks over new financial regulations.
Nonetheless, the Bank of England will have to keep a close eye on U.K. housing prices, which have grown at a 1.2% quarterly rate between April and June, although more slowly than early in 2016. Near-zero interest rates may cause the financial sector to seek higher returns in other asset markets, potentially inflating a housing bubble.
Even so, the situation in the U.K. is unlikely to evolve along the path that the U.S. housing market found itself on during the early-to-mid 2000s. Two additional factors—capital inflows from abroad and financial deregulation—contributed to the U.S. housing bubble that will not apply to the U.K. in the immediate future. In addition to low interest rates in the aftermath of the 2001 terrorist attacks and the dot-com crash, U.S. housing prices were fueled by capital inflows into the U.S., as central banks of many developing countries looked to shore up their foreign reserves following the Asian financial crisis of 1997-1998, and by proliferation of obscure financial instruments that allowed lending institutions to repackage and sell off risky investments, encouraging the issuance of subprime mortgages.
The next several months are going to define the international environment in which the Bank of England will have to operate to keep the economy on track. EU leaders insist that trade negotiations will not take place until Britain triggers Article 50 of the Treaty of Lisbon to officially indicate its withdrawal from the EU. This is giving pause to the U.K. government, fearful of losing access to its largest trading partner (accounting for 44% and 53% of exports and imports, respectively). Since the Brexit referendum is advisory rather than legally binding, the U.K. government still has the option—however unlikely—to ignore its outcome and instead try to work with the EU to address the issue of migration, apparently central to the British public. Given this very wide range of possible political outcomes, Carney would be best advised to hold the interest rates steady to allow himself room to maneuver a few months down the road.
