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How interest rates work

• Evan Davis | Small Change |
• 11 Jan 08, 10:14 AM

This is an article dedicated to Kevin Hawkins.

He is the director general of the , and probably the most effective trade association representative I have encountered.

He is a wonderful communicator, who avoids the kind of studied, cautious, mealy-mouthed jargon of many public figures. He’s always feisty and never apologises for representing the interest of his members. He’s earned his OBE, and when he stands down from the BRC soon, they (and I) will miss him.

I’ve heard him talk about supermarkets, minimum wages and chickens.

But in the field of macro-economics, there is one message that Kevin Hawkins delivers regularly and repeatedly: that it’s time for the Bank of England to cut interest rates.

He appears to do it month after month. For the BRC, it’s almost always time to cut interest rates.

We’ve been through a decade of incredibly robust consumer spending, and yet I can never remember him asking for a rate rise to tame the excesses of the consumer.

In making the case that rates need to fall, Kevin is perfectly representing the desires of his members and I make no criticism of him.

But how relevant is that call in 2008? How successful will those interest rate cuts be at helping the shops?

A little diatribe on the economics of interest rates is useful here…

Interest rate cuts have an effect in stimulating an economy by directly or indirectly making someone, somewhere, spend more than they otherwise would.

That extra spending increases demand and ensures that we all carry on with work to do, without us having to slash our prices or our wrists.

There’s always a dilemma about whether cutting rates threatens inflation - that’s the essence of the decision the MPC has to make each month.

But there is an interesting secondary question to ask of interest rate cuts when they occur. Which spending is it that they are expected to encourage? How will lower rates work their magic on the economy?

In principle, there are only three main components of spending that much matter to monetary policy: consumer spending, business investment and exports and trade.

Taking the three in turn, we consumers are encouraged to spend by lower rates in a number of ways:

- they change our incentive to borrow and save,
- they change the income available for spending for some of us and
- they affect the price of our houses, thus affecting our perception of how much spending we can afford.

When rates are not driving consumption, they affect business investment in a number of ways too. Lower rates tend to cut the cost of capital, which companies use to pay for investment.

As far as trade is concerned, lower rates work through sterling. They mean people are less inclined to park money in Britain; they buy fewer pounds (after all, they earn less interest on them) so sterling falls, and that promotes exports (as well as discouraging imports).

The Bank of England, when making a decision on rates, doesn’t have to care much about which of these mechanisms transmits lower rates into economic action; all have the effect of stimulating the economy at the cost of potentially raising inflation.

Now in the recent past, consumer spending has been the active ingredient in the economy – the years of easy money have encouraged consumers to borrow and buy. And we needed consumers to do that in order to soak up the huge supply of manufactured goods coming into the global market from China.

Those days were good for consumers, and for the shops.

But many people - including some of the retailers themselves - appear to work on the casual assumption that if consumer spending is now drying up, all that is needed is for rates to go down to a level at which it takes off again.

That may have been right in 2001. It may not be right for 2007.

The reason is that saving in the UK is still relatively low. At 3% of household disposable income, we are saving at half the long term rate.

Do we expect or want interest rates to drive saving even lower? After all, we have many problems in the UK, but a reluctance for consumers to shop is not one of them.

Fortunately, consumers will decide for themselves whether they want to spend or whether they want to stop. And consumers will look beyond interest rates.

If house prices fall for example, we might all feel we overdid it last year, and choose to be more cautious now.

That means even if interest rates fall this year, they may not do much to stimulate the economy by promoting consumer spending. They might prevent an abrupt and disruptive halt to consumer spending, but I wouldn’t necessarily think of it as likely (or even desirable) that they do much more than that.

To summarise - if the game is up for consumer-led growth, there may not much the Bank of England can do about it.

So does that mean the economy is doomed? Possibly. Lower rates might promote business investment, but in truth, businesses are not normally much inclined to invest if there are not going to be customers for their products.

Burt there is one remaining thing rate cuts can achieve: they can lower the pound and help exporters sell more. The Americans have pulled off this trick to some extent (although there is a long way to go). The British may follow.

That would be good for the economy (if it is not too inflationary); it would keep us in work, while at the same time allowing us to sort out our personal finances.

The only problem is that improving our trading position would do almost nothing to help Marks and Spencer, other retailers or estate agents.

Indeed, a lower pound can hurt British retailers, who often source from overseas and find their imported goods more expensive. It squeezes their margins.

Kevin Hawkins is probably right to call for rate cuts - the economy probably needs them and will probably get them.

He may be disappointed to find they do little to help his members.

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