Page last updated at 15:08 GMT, Thursday, 4 December 2008

Where will interest rates go now?

Graph shows Interest rates since 1951

BBC economics editor Hugh Pym
By Hugh Pym
BBC economics editor

These are uncharted waters for the Bank of England, both for members of the Monetary Policy Committee and pundits who try to second guess their decisions.

We became so familiar with interest rate moves of one quarter of a percentage point over many years that even half point changes seemed highly unusual.

Now, two big rate cuts in as many months have changed the landscape.

The dramatic 1.5% cut last month has been followed up by a 1% reduction at noon this Thursday.

No surprise

The markets were not taken by surprise this time. The market consensus had begun to coalesce around the full percentage point cut in the days leading up to the announcement.

But that does not make it any less significant.

If you think rates might need to fall a bit further from where they are now, why hang around?
Hugh Pym

The cost of borrowing has now more than halved since the 5% prevailing till as recently as early October.

The background to the decision was an extremely fragile economy, with activity falling even faster since the last rate cut.

The Bank of England pointed to this in its own statement explaining why it cut rates, saying that "business surveys have weakened further and suggest the downturn has gathered pace".

This week's indicators from manufacturing, construction and services suggest further steep declines in confidence and output.

Recession watch

The UK is all but in recession.

Final confirmation of that won't come until the fourth quarter output figures are published in mid -January.

ALSO IN 1951...
Festival of Britain 3-D cinema audience
January-June, Korean War saw heaving fighting across the 38th parallel
May, King George VI opened the Festival of Britain
October, the Conservatives won the general election
The average house cost 2,100
A loaf of bread cost 6d (2.5 pence)

But they seem certain to reveal another fall in gross domestic product, quite probably even sharper than the third quarter's decline of 0.5%.

The question for the Bank is whether to move the cost of borrowing even further or whether to keep something in reserve as recession looms.

Further action might be seen as necessary to steer the economy away from a steep and prolonged recession

In other words, if you think rates might need to fall a bit further from where they are now, why hang around?

Zero rates?

Professor Willem Buiter and Professor Charles Goodhart are two former members of the Monetary Policy Committee.

They told me they were in no doubt that rates would move eventually to zero or not far above it.

But they both highlighted the danger of a slump in the value of sterling.

The pound has fallen significantly since the summer as foreign investors reappraised the prospects for the British economy.

On a trade-weighted basis, it now stands at its lowest level since 1996.

Higher levels of household debt than in many other industrialised nations started to ring alarm bells.

The UK is perceived as more risky than many competitor economies.

Sterling did pick up a little after the rate decision, but only from new lows reached this morning.

It is a delicate balancing act.

If the Bank of England moves too aggressively on interest rates, confidence in the currency could be further undermined.

If the UK central bank was seen to be reducing the cost of borrowing more rapidly than others, incentives to hold sterling might be further diminished.

However, the fall in the pound has boosted the prospect of a rebalancing of the economy away from imports towards export-led growth.

But if an orderly decline turned into a currency rout, that would be a nightmare for the authorities.

Professors Buiter and Goodhart agree that big cuts in rates are necessary.

But they warn that currency fears may restrain the Bank just when restraint may be the least advisable option.

Right now the cost of borrowing, at 2%, is the lowest since 1951.

A further cut would take it to levels unseen since the Bank of England was founded in 1694.

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