High, real rates of interest

7th December, 2008

On friday 5th December the Financial Times finally acknowledged that ‘real borrowing costs remain high‘. For those readers that may have missed it let me recap: UK interest rates are now at 2%. The three-month Libor rate (the London inter-bank offer rate – fixed by a committee of the British Bankers Association) has come down from 6% to just under 4%.  Mortgage rates for new borrowing are just under 6%. The cost of borrowing for companies (loans and overdrafts) is at 7%. The yield on UK corporate bonds (BBB) are just under 12%.  Lets hear no more about low rates of interest.

Real borrowing costs remain high

By Chris Giles, Economics Editor, Financial Times

(continued from previous page)

Cuts in interest rates are designed to boost demand in the economy in three ways. First, they should encourage people to save less and spend more; second, they should boost the incomes of borrowers, who tend to be shorter on cash than savers; and third, they should damp the exchange rate, boosting Britain’s trade performance.

But with demand in other countries as weak as in the UK, net exports are unlikely to increase quickly, in spite of sterling’s 20 per cent fall on a trade-weighted basis over the past year. Nevertheless, the Bank on Thursday stressed in its statement that it was pleased with the pound’s decline. “The further depreciation in sterling should moderate the impact of weaker global growth on the UK,” it said.

The main problem, however, is that the changes in official interest rates – both when they were rising in 2006 and 2007 and now that they are falling – have barely been passed on to most households and companies. An aversion to lending to anyone in the private sector has left short-term government paper as the only asset class that has tracked the official rate more or less closely. The yield on two-year government bonds was below 2 per cent on Thursday, with slightly higher rates for longer-dated paper.

Banks, which borrow at Libor (London interbank offered rate), have also seen a sharp reduction as official rates have fallen. But there are doubts on whether Libor is anything other than notional at the moment because banks are struggling to fund themselves at this rate. Mervyn King, the Bank governor, made a joke about this last week, saying Libor was “in many ways the rate at which banks do not lend to each other, and it is not clear that it either should or does have significant operational content”.

Mortgage rates for new borrowing have remained stubbornly high, reflecting this high cost of funding for banks. Only households with existing variable rate mortgages will see a big benefit from the rate cuts.

But it is companies that have gained the least from lower official rates. The cost of their borrowing from banks has been remarkably stable, at about 7 per cent, over the past two years. Fears of default have led to an explosion of the cost of borrowing in the corporate bond market for low-quality investment grade companies even as rates have fallen. Top-notch companies have also seen little benefit.

These limited movements in the interest rates people and companies pay and the lack of available credit are the direct result of the credit crunch. It is not surprising the monetary policy committee noted “it was unlikely that a normal volume of lending would be restored without further measures”.

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