The outgoing governor of Bank of England, Mark Carney, on Thursday 9 January 2020 announced that the central bank is contemplating another rate cut if the growth situation in the British economy does not improve. This statement come amidst widespread concerns of a worldwide liquidity trap situation developing as major world economies have been on a rate cut spree to spur growth in their domestic economies. This has flooded the world markets with excessive cash flows. The recessionary conditions this time, it seems, is too deep for the central banks the world over to be out of their wits to deal with.
In monetary Economics the concept of interest rates has a special significance. In the hands of central banks, it is a powerful tool to balance the many factors which are impacting an economy, which if not carefully regulated would lead to disastrous consequences. In times of weak economic activity in an economy, with a pessimistic business outlook or if the unemployment rate is rising in the country, the central bank would tend to lower interest rates. This in turn will prompt commercial banks in the country to lower their interest rates as a consequence, thereby prompting businesses to borrow more which will initiate new business activity in the whole economy. Similarly, when the central banks feel that there are inflationary conditions prevailing in the economy, they will increase the interest rates so that the excess purchasing power in the hands of people is curtailed leading to the softening of demand and consequently prices will come down, and with it, inflation. In fact, it is the primary function of the central banks to constantly monitor the economy and use the monetary tools at their disposal to guide the economy in the right path. Looking at it from a different angle, a lowering of interest rates would mean that surplus funds would flow into the system and a hiking of the interest rates would imply that surplus funds are being sucked out from the economic system.
The past few years have been a period of turmoil for the British economy. Brexit, or the withdrawal of United Kingdom from European Union, brought with it several unanticipated consequences, which threatened to severely hamper business activity across the continent. As a measure to deal with the likely eventualities after Brexit and also to arrest the slowdown currently unfolding in the country due to the uncertainties among British businesses and citizens at large regarding the future of the British economy, The Bank of England has started to lower interest rates. The pessimistic conditions, however, prevailing in the British economy are proving too much for the curative measures being taken by the Bank of England to tackle it. The Bank's Financial Policy Committee which had congregated on 2 October 2019 had given the opinion that the entrenched uncertainties regarding Brexit, particularly in the weaker global growth environment scenario, has continued to materially weigh on the British economy, including on business investment, the prices of British assets and flow of foreign capital into the United Kingdom. The most notable effects of the slowdown have been in the commercial property markets and the leveraged lending markets.
The international economic environment has not been conductive lately. The International Monetary Fund in its report has cast serious apprehensions regarding the slowdown of the global economy accentuated by the many factors including that of Brexit and the United States- China trade war situation. The impact of this trade war situation on the world economy has also been significant; it has had a depressing effect on the business sentiments across the world as both sides together command the lion’s share in the global trade of goods and services. Weaknesses in demand- supply dynamics and a tweak in trade tariffs between these two countries have the ability to disrupt the demand-supply equilibrium of the world markets. This not only impacts commodity markets but also has a cascading effect on the world currency and equity markets. The IMF in its World Economic Forecast report published in 2019 had painted a not so encouraging picture of the world economy and has held China - United States trade war as a major factor resulting in the same.
Another important factor that influences the interest rate change of Bank of England is the interest rate policy of the United States Federal Reserve. United States, being the largest economy of the world, exerts a significant impact on the world currency markets. Whenever an interest rate change is announced by the Federal Reserve, there is a cascading effect on the currency and equity markets the world over. Currently, given the weak global economic outlook, the federal reserve has also announced a rate cut, leaving little room for the rest of the central banks to walk the same route to bring about desired changes in their respective economies.
The statement made by Mark Carney had an immediate impact on the Pound Sterling, which fell sharply to a near two week low against the US Dollar on Thursday’s (January 9, 2020) trade. The British economy in the past year has grown the weakest since 2012 and despite the overall optimism after Prime Minister Boris Johnson’s coming back to power in the December 2019 general elections, many of the important economic indicators still continue to reel under pressure. The governor’s statement in this regard gets even more credence, as two of the nine members of the bank’s interest rate committee have voted to cut interest rates from the current 0.75 per cent to 0.50 per cent recently. However, what needs to be kept in mind at this juncture is that the marginal effectiveness of an interest rate cut may be very low this time in achieving its intended objective. In fact, the better course of action would be to use the available policy measures by the treasury of the United Kingdom to spur growth in the economy, as this will also address several key structural issues affecting the economy at this time. The British economy is facing the possibility of transformative changes as its approaches the Brexit date and surplus cash situation may not be the most appropriate condition to have in order to implement any long-term policy initiatives.
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