Explaining the Bank of England’s High Interest Rates

bubbleIn its front-page curtain-raiser for the Bank of England’s rate cut today, the WSJ prints a chart with the headline "Banking Bubble?". It shows that the financial sector now accounts for more than a fifth of all jobs in the UK – compared to just 6% in the US.

So how is it that the UK, with an enormous financial sector and a rapidly-imploding housing market, has interest rates far above those in the US and the euro zone? After today’s cut, the UK base rate is 5.25%, compared to 4% in Europe and 3% in the US. Inflation is a bit of a worry in all three areas, but I don’t think that inflation on its own can account for the differential.

Rather, I suspect that the Bank of England is quietly not at all unhappy that the housing-and-finance boom seems finally to have come to an end. It was always unsustainable, and while there’s no pleasant way for any bubble to burst, a slow deflation, like we’re seeing in the UK, is always preferable to a nasty crash. If the Bank cut rates aggressively, it would risk reinflating the bubble, which would only make an eventual crash more likely and more painful. So it’s happy to let the air out slowly, and if panic does break out, it has much more room to cut than the Fed or the ECB.

This entry was posted in fiscal and monetary policy. Bookmark the permalink.