Page last updated at 00:04 GMT, Thursday, 6 November 2008

How low can interest rates go?

By Hugh Pym
BBC economics editor

The Bank of England Monetary Policy Committee (MPC) is widely expected to cut interest rates today.

Cogs
A rate cut should help keep the economic cogs turning

A reduction to 4% from the current level of 4.5% is almost taken for granted by the financial markets, but could the MPC go further? And should they?

This is another tough call for the Bank of England. The issue is not whether to cut but by how much.

The debate is no longer about high inflation. With oil and commodity prices plummeting, it is expected to fall rapidly from its current 5.2% rate.

The thorny issue for policymakers is whether a severe downturn will grip the British economy.

The Bank's concern is that if there is a prolonged recession, inflation will fall so much below its 2% target that letters of explanation to the chancellor will be needed.

Bold move

So there is every incentive to reduce rates by another half percentage point, following October's move.

We need a real shock to the system that a significant rate cut will provide
David Smith, chief executive, Jaguar Land Rover

Some in the business world are demanding a cut all the way down to 3.5%. They argue that consumer confidence is so fragile that only a bold move would have any effect.

Even the CBI has joined this camp, which is especially significant as a former member of the MPC, Richard Lambert, is now heading the employers' organisation. He would not have joined the 1% cutting club if he did not think it was a realistic option.

Jaguar Land Rover, now part of India's Tata group, is one leading UK-based company that has gone public with a call for a one percentage point reduction.

"We need a real shock to the system that a significant rate cut will provide," chief executive David Smith said.

Business leaders of that ilk do not go public with such a call if they are not highly concerned about the economy and convinced that a big cut is achievable.

An immediate reduction to 3.5% would be the Bank's biggest cut since gaining independence in 1997.

Lone voice

Even a few weeks ago it would have seemed inconceivable to all but Professor David Blanchflower.

He was a lone voice on the MPC urging rapid and significant cuts in rates because of the severity of the recession threat.

He is now entitled to say "I told you so". Other members will argue that the scale of the banking crisis since the collapse of Lehman Brothers in mid September took everyone by surprise.

A troubling thought for members of the MPC is that there is no guarantee a rate cut would be passed on in full by banks, as they continue to restrict lending.

This was recognised in a speech last week by Professor Tim Besley.

"Conventional transmission mechanisms" for cuts in the official bank rate had been restricted, he said.

Given that Professor Besley was an inflation hawk until recently, and voted for increases in interest rates, this is an intriguing observation.

It might suggest that there is another lively debate running at the MPC. Those who were worried about the inflation threat might argue that there is no point cutting rates too much if the effect is going to be limited.


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