Libor is key to BoE interest rate cut

In normal economic times a 1.5 percentage point cut in UK interest rates would trigger a surge in share prices and a stampede to high street banks and estate agents, as mortgage rates tumble. But when the Bank of England cut rates from 4.5% to 3.0% on 6 November 2008 – ­ the biggest cut since 1992 and to the lowest rate since 1954 – ­ the silence was deafening. Shares fell, mortgage lenders refused to cut their rates and even withdrew ‘tracker’ deals for new borrowers that would have lowered borrowing costs.

Pressed by Alistair Darling, most banks relented in a couple of days, passing on the full cut to homebuyers on standard variable rate mortgages after Gordon Brown called in their chief executives and the media dubbed them “interest rats”.

But the reason for their sluggish response was that the rates banks offer to homeowners and businesses depend on the price they pay to raise money on the open market, using the London Interbank Offer Rate (Libor). Normally 0.1% to 0.2% above the official rate, sterling Libor was 5.56% on the day of the cut – ­ that’s 2.56% above BoE rate.

Media offensive
Sensing a media backlash if banks failed to cut rates, the Council of Mortgage Lenders (CML) stressed that the real cost to lenders was three-month Libor and not the BoE’s Bank Rate.

“It does not make commercial sense to insist or expect that lenders automatically ‘pass on’ cuts in Bank Rates to borrowers unless, and until, the cut flows through to an equivalent reduction in their own funding costs,” a CML spokeswoman said.

One reason the Bank cut so steeply may have been because previous rate cuts had so little impact. After cutting by 0.5% in October, mortgage rates fell just 0.01%. By 20 November, Libor had fallen to 4.0%, down more than one percentage point, but still 1.07% above the BoE rate.

“We have been warning investors for several months that it does not matter what happens to official interest rates but what happens to effective rates,” says Andrew Milligan, head of global strategy at Standard Life.

“The effective rates that one pays are too high and even higher than a year ago. They need to come down significantly over the next six months for monetary easing to provide the impetus for economic growth in 2009.”

Stephen Lewis, chief economist at Monument Securities, says Libor remains high because lenders simply do not have the liquid cash to lend to consumers. “The problem is that the benefits of [the rate cut] could well turn out to be short-term political, rather then medium-term economic,” he says. “If money market illiquidity continues to constrain financial institutions’ willingness to lend, the chief effect of a forced reduction in lending rates is likely to be a tightening in credit standards.”

Capital injection
Since he sees it as a liquidity problem, Lewis says the only solution is for governments to inject capital into banks and other lending institutions. He says while the UK led the way with its plan to recapitalise the banks, it has adopted a much more cumbersome procedure than the US Treasury, which is already putting money into US banks. “This may be one reason why the credit thaw is more rapid in dollar than in sterling markets,” he adds. Dollar Libor is 1.15% above the Fed Funds rate.

Though Libor is what matters, economists believe the BoE must carry on cutting rates. “If credit supply does not show any material recovery over the next few months the policy rate may need to be cut to 1% or even lower,” says Simon Hayes, UK economist at Barclays Capital.

David Owen, chief European economist at Dresdner Kleinwort, says the narrowing is proving “painfully slow”, with little interbank lending across Europe. “The hope is that things will improve before year end, but the longer this continues the more likely that banks turn the tap off for companies,” he warns. “If that happens, recession will worsen.”

For more on the rate cuts, read our blog.