Thursday, November 06, 2008

Bank Of England's Shock Cut

Following recent similar moves by the Fed and the Swedish Riksbank, the ECB and the Swiss National Bank both cut their official interest rates by 50 basis points. But compared to the surprising drastic 150 basis point cut by the Bank of England today, these cuts looked like hawkish moves in comparison.

The Bank of England now has lower interest rates (3% versus 3.25%) than the ECB for the first time ever during the 10 years that the ECB has existed. Considering that risk premiums on credit markets have declined and considering that inflation in the U.K. is more than 5%. The sharp decline in the price of oil probably means that inflation will fall even in the U.K., but considering how weak the pound is, inflation will probably not fall to the 2% target. The Bank of England is apparently so scared by the present U.K. downturn that it in effect has suspended its inflation target. Given that inflation targeting isn't a good idea that is not necessarily a bad thing. But suspending it in an asymmetric way (ignoring it when inflation overshoots, while adhering to it when it undershoots) implies a strong inflationary bias.

While everyone is now trapped in a Keynesian mindset that only the short term matter, we shouldn't forget that it was the previous inflationary bias that created these problems in the first place, and that doing it again will create more problems. That is why it is good to see that there seems to be some central bankers who remember this. ECB executive board member Lorenzo Bini Smaghi commented the call for even more drastic cuts (like Bank of England's) this way:

"The present crisis is partially due to interest rates that remained at low levels for too long. At that time, rates were lowered too much in order to stimulate growth. We need to avoid repeating the same mistakes."


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