When central banks lose control of interest rates

Just after the Bank of England’s stunning 150 basis point cut yesterday, BBC business editor Robert Peston noticed an alarming signal of problems ahead.  He wrote:

I’ve just had a call from an astonished individual who has several hundred million pounds that he puts on deposit in various banks. As of 10 minutes ago, a leading British bank was offering to pay him almost 7% interest for his cash. That was after the Bank of England’s policy rate had been slashed by 1.5 percentage points to 3% – an unprecedented reduction in the history of the Bank’s Monetary Policy Committee.

Why does it matter that this holder of squillions is still being offered almost 7%? Well, if he’s being paid almost 7%, what chance is there that small businesses will be able to borrow at less than 10, 12, 14% or more (with the actual rate depending on an assessment of their credit-worthiness)?

Peston’s conclusion: “the transmission mechanism from the Bank of England’s policy rate to the interest rates we pay has broken down“.  This morning, the front of the FT confirms the problem:

All but two UK banks snubbed government calls to pass on Thursday’s dramatic interest rate cuts to new customers and more than 20 lenders withdrew deals that would have slashed borrowers’ monthly mortgage repayments … Lloyds TSB and Abbey were the only two lenders to say they would pass on the full rate cut in their standard variable rates.

What’s at stake here is potentially rather larger than simply the question of providing some much-needed relief for mortgage holders and small businesses, or the political issue of whether banks in receipt of taxpayer bailouts have a duty to pass on the rate cut. 

No, the bigger question is about the degree and efficacy of state control over monetary policy – full stop.  Here’s how it’s supposed to work in the words of the Bank of England:

When the Bank of England changes the official interest rate it is attempting to influence the overall level of expenditure in the economy. When the amount of money spent grows more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to control inflation.

The Bank of England sets an interest rate at which it lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers.

Well, that’s the theory, anyway.  But what happens if it no longer works?