Page last updated at 08:41 GMT, Thursday, 5 March 2009

UK rates expected to fall further

Exterior of the Bank of England
Low rates force the Bank of England to use unconventional measures

The Bank of England is expected to cut interest rates to a fresh all-time low and start increasing the money supply in an attempt to revive the economy.

Most analysts believe the Bank will cut rates to 0.5% from 1%. An announcement is due at 1200 GMT.

As rates get closer to zero, the Bank runs out of room to cut the cost of borrowing to stimulate the economy.

As a result, the Bank is expected to try a new method of pumping extra money into the system.

Economists suggest that it could opt to expand the money supply by up to 150bn ($212bn).

Britain fell into recession last year, for the first time in nearly two decades, after the global financial and economic crisis intensified.

This saw the UK economy contract 0.6% between July and September, and then by 1.5% from October to December.

The latest set of jobless figures showed that UK unemployment rose to 1.97 million between October and December, the highest level since 1997.

Quantitative easing

The Bank is expected to try and boost the money supply by a new measure - so far untried in the UK - called quantitative easing.

It is sometimes referred to as printing money, but it will not expand the supply of money by making new banknotes.

Instead, it would buy assets - such as government securities (gilts) and corporate bonds. But as it will not borrow to fund the purchases, it is creating new money.

Similar measures were implemented in Japan at the beginning of the decade and are considered to have had limited success.

Increasing the supply of central bank money via purchases of government securities should help to loosen these restrictions and boost the supply of money and credit
Hetal Mehta, Ernst & Young ITEM Club

Philip Shaw, chief economist at Investec, said that if the Bank decided to try quantitative easing, it "should in principle encourage the banks to lend to private sector agents such as households and businesses, stocking monetary growth and stimulating activity".

However, many analysts are uncertain about whether boosting the domestic money supply would be effective.

The Bank of England revealed in February it had asked for government approval for quantitative easing.

Chancellor Alistair Darling hinted in an interview on Tuesday there was a possibility that measures to boost the money supply would start this week.

Hetal Mehta, senior economic adviser to the Ernst & Young ITEM Club, said: "Credit starvation is the biggest problem facing the UK economy and increasing the supply of central bank money via purchases of government securities should help to loosen these restrictions and boost the supply of money and credit."

Key problem

There have been concerns that cutting interest rates further could hit banks' profits, leading to a further lending squeeze, which in turn would lower chances for an economic recovery.

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Shelagh Heffernan, Professor of Banking and Finance, said: "Dearth of loan supply is the key problem, not weak demand. Lower rates will not encourage more lending.

"Raising rates would attract more deposits which banks could lend on, and make lending more attractive."

But Hetal Mehta disagreed: "While another rate cut would further squeeze banks' profitability and might reduce their incentive to lend, it would have the benefit of supporting spending for corporate and other borrowers with floating rate debt, particularly those with tracker mortgages."

Concern has also been raised that a further fall in interest rates would unfairly penalise savers.

The Building Societies Association said it would be a "savage hit" for savers if rates do go down again.



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