Why interest rates are higher than you think

By Associate Editor David Stevenson Jun 05, 2008

David Stevenson

So, no change to British base rates.

The Bank of England’s decision to keep the base rate on hold at 5% was no shock to the City. After all, last month the consumer price index (CPI) hit 3% (the highest it can go before Bank governor Mervyn King has to write to the Treasury and explain himself), and the Bank has forecast that the CPI may rise over the summer to almost 4%, as food and energy costs continue their upward surge.

So despite the increasingly desperate pleas from retailers and estate agents, with Halifax today reporting a 2.4% May house price fall, that interest rates should be slashed to shore up the faltering economy, it’s good to see that the Monetary Policy Committee isn’t completely shirking its responsibilities.

Worrying about the looming recession isn’t its problem. Controlling the CPI is, and 2% is the target, so base rates should certainly stay where they are for some months if that’s to be reached – although the way the money markets are behaving at the moment, the Bank doesn’t really have much say in the matter.

Why? Because these days, swap rates are the real deal. These are the rates at which financial institutions like banks borrow from each other, and form the basis for LIBOR, the London interbank offered rate, and ultimately the cost of money that lenders charge us when we want to borrow.

In other words, swaps are set by the money markets, unlike the ‘artificial’ base rates set by the Bank of England. And right now, one-year swaps are standing at just under 6%, i.e. almost a full 1% higher than ‘official’ borrowing costs.

Why does this all matter?

When swap rates are so much higher than base rates, like now, building societies and lenders who need to borrow funds from the money markets have to shell out more for the cash. So they have to charge more for mortgages, hence monthly repayment costs rise.

That slows up loan demand and should eventually filter through into lower prices in the shops. But with oil prices in particular at such high levels, that could take some time, which is why the Bank can’t afford to take any more risks with CPI.  

Bank of England Governor Mervyn King may already be feeling a bit pressured, having warned that he’s likely to need to write a series of letters to the Chancellor explaining why inflation has risen more than 1% above target.

Yet right now, the Governor should also be feeling quite lucky. Because the money markets have taken on the uncomfortable role of managing the money supply for him.

Published in Economics | More articles by David Stevenson

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