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An interest rate of 1.5% is certainly low, but it is surprising that the Bank of England has not gone further given the bad news about demand since the previous month's announcement.
A bigger rate cut would have lowered the monthly payments of interest by businesses (helping them survive a period of lower sales without being forced into bankruptcy), and by mortgage borrowers (helping them survive a period of unemployment without being forced into foreclosure). At present interest rate cuts are not being entirely passed on to borrowers by banks, but a lower rate will lower the costs of funds that the commercial banks face, increasing their profits, and helping them to accumulate the capital that they have recently been lacking. An economy full of teetering firms, homeowners, and banks are crying out for lower interest rates.
Nevertheless the Bank of England has an official mission statement – to maintain CPI inflation at 2% – and the Bank's projections of CPI inflation in 2009 show that it does not expect to depart very far from this target.
Inflation targeting is one of the great inventions of economics: a very simple discipline to solve the postwar problem of inflation being generated by perverse political incentives, and it seems to have worked in solving that problem. In normal times it would also provide a stimulus when demand is low, but recently in the UK it has caused some strange monetary policy decisions.
One problem is that CPI is affected strongly by international commodity prices, meaning that the Bank's target can jump around because of largely irrelevant forces. This is the reason for the Bank's agonising hesitancy to drop rates in 2008, because at the same time that domestic demand began to crumble – indicating future deflation – the price of petrol and food was going up.
A second problem is that CPI is affected strongly by the exchange rate, and while commodity prices have now receded, the cost of imports has shot up, because of a devaluation of the pound by 25% since August. This
rise in import prices is expected to push CPI up, reassuring the Bank's governors that they don't need to cut rates much to meet their target, despite the recent series of domestic firms announcing redundancies or bankruptcy.
The Bank of England's inflation targeting charter has provided great stability since its introduction in 1997, but the governors would be doing us a favour if they now interpreted their mission statement a little less literally.
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