Is a high effective interest rate the reason the Bank rate remains so low?

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Yesterday, in response to the minutes from the MPC's meeting, Chris Giles at the FT's Money Supply blog noted that the MPC was concerned that the margin of spare capacity in the UK economy may be low:

“Survey measures of capacity utilisation had suggested that some spare capacity remained in the service sector, although less than a year ago, while capacity utilisation in the manufacturing sector appeared at around normal rates”Spare capacity is needed for non-inflationary economic growth. All else equal, the lower the margin of spare capacity the higher interest rates need to be. This is the thinking behind the Taylor rule (a formula for setting monetary policy). As Giles notes:

“If there is no spare capacity, the level of interest rates suggested by the rule (on current CPI inflation) is 7.75 per cent”

As Giles puts it “interest rates of 7.75 per cent are nuts”. But, at 0.5%, the base rate is considerably below this mark.

Part of the reason will be that the Bank's base rate isn't the actual interest rate that is paid by banks, companies and consumers in the real economy. As Mervyn King noted back in the inflation report press conference:“I think the key, from our point of view, to what has been happening, and the reason why Bank Rate has been set at such a low level - if you look at Chart 1.9 … what you can see is the enormous gap, relative to historical experience, between the rate at which banks are paying for their funding and Bank Rate. And obviously that explains why Bank Rate is in large part so low, because if we were to raise Bank Rate, that would push up further the cost of funding to banks”

Put simply, as long as there is a significant difference between the Bank Rate, and the rate at which banks can get their funds, the effective interest rate faced by the rest of the economy is somewhat higher.

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