Pushing string/pulling elastic

Just to set the scene for the Bank of England's interest rate announcement of later today ...

1. There is a perfectly sound economic theory that says if the markets are getting over-heated, the Bank of England can rein then in again by hiking its interest rate. Commercial banks will only lend money to borrowers if they can earn at least as much as they can by depositing it with the Bank of England, plus a risk premium. So if the Bank of England increases its rate by 1% (or '100 basis points' to use the jargon), commercial banks increase the rate they charge borrowers by 100 bps.

That's called "pulling a piece of string", and broadly speaking it works.

2. But once confidence has evaporated, no amount of cutting interest rates can bring it back. If banks don't trust borrowers, and if both banks and borrowers know that that house prices have a long way to fall, they would be daft to lend/borrow money at low interest rates, especially as the banks in turn have their own creditors snapping at their heels. In these circumstances, if the Bank of England cuts the interest rate that it will pay on the money that commercial banks deposit with it, it has no effect on actual mortgage rates (apart from those that are contractually linked to the Official Base Rate). This effect is referred to "pushing a piece of string".

3. As I learned recently, the Monetary Policy Committee used to have the easiest job in the world - all they do is set this month's Official Base Rate to be about 20 bps lower than the current Three Month Libor Rate, have a cup of tea and a few biscuits and collect their monthly retainer on the way out. Follow the link and look at the second chart for evidence, a coincidence? I think not. Nowadays, their job is even easier, they just do what the government tell them.

4. The interest rate at which one commercial bank will lend to another (the London Inter-Bank Offer Rate, or LIBOR) for three months is normally about 20 bps higher than the Official Base Rate, because of course it includes a very small risk premium. Inter-bank lending on its current scale is a relatively new phenomenon - until five or ten years ago there were only small amounts involved as banks oiled each others' wheels, and it has only increased to its present massive scale as part of the credit bubble that so many mistook for economic growth.

5. Nonetheless, the 'pushing a piece of string' analogy has its limits. Banks will still lend to other banks, provided the risk premium over and above what they can get by depositing it with the Bank of England justifies it - so while the Official Base Rate has been pushed down to a ridiculously low level, it has (so far) more than compensated for the additional risk premium, which is why Three Month LIBOR has come down (see chart in earlier link).

6. This is what I shall henceforth refer to as 'pulling a piece of elastic' - for every 100 bps that the Bank of England reduces the Official Base Rate, Three Month LIBOR (and by extension, mortgage interest rates) only goes down by, say, 50 bps. Which begs the question, what on earth will happen if and when the Official Base Rate goes up by 100 bps again - presumably mortgage rates will also go up by 100 bps, leaving over-stretched mortgage borrowers in an even bigger mess than then they had ever feared?

7. To illustrate the 'elasticity', here's a chart of Three Month LIBOR divided by the Official Base Rate since 1978 - the last few months are really quite extraordinarily high (which means that commercial banks are either desperate to borrow from each other or steadfastly refusing to do so):8. The only previous spikes, where Three Month LIBOR was a tenth more than the Official Base Rate (i.e. above the 1.1 line on that chart), were in 1983, when all Hell was breaking loose, economically, and the UK had [had] the Falklands War going on [a year earlier]*; and very briefly in 2001, when the government, oops, 'The fully independent Bank of England Monetary Policy Committee' decided to crank up consumer demand a bit after the ill-fated dot.com crash. We've now exceeded that ratio for over a year. Bode well, this does not.

* Nick D, thanks, my bad.