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FT: Fiscal policy is our most potent instrument

Author: Wolfgang Munchen
November 9, 2008

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The Bank of England's extraordinary 1.5 percentage point interest rate cut to 3 per cent is scary, justified and irrelevant. It is scary because it confirms the British economy may be headed for one of the biggest slumps since the second world war. It is justified in the sense that falling inflation rates give central banks sufficient room for manoeuvre. But unfortunately, it will not make much difference to the prospects of an economic recovery.

A stronger eurozone rate reduction by the European Central Bank, which cut by half a percentage point to 3.25 per cent, would also have been desirable and justified, but likewise irrelevant.

The reason is that the channels through which monetary policy affects the real economy are still clogged. There are several such channels, including ones for bank lending. But most of them go through the money market, as neither companies nor households have direct access to central bank money. To the extent that the money markets are not working properly, monetary policy is correspondingly ineffective.

As British variable-interest mortgage holders discovered to their dismay last week, most banks were initially reluctant to pass on the Bank of England's cut, although they later said they would do so. The rates that matter to mortgage-holders are short-term or long-term mortgage rates, depending on the type of mortgage they hold.

What matters to many companies is the London interbank offered rate (Libor), or the Euribor in the eurozone. Large companies often fund their short-term liquidity needs on the commercial paper market. The US Federal Reserve has cut the Fed funds rate from 5.25 per cent in September 2007 to 1 per cent recently. But 90-day commercial paper rates were a little over 5 per cent when the crisis started in August 2007 and still close to 5 per cent last month. Only recently have they fallen to 3.3 per cent, and only after the Fed started to intervene in this market directly.

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