Will UK interest rates fall to 0%?
Andrew Oxlade, This is Money
28 October 2008

American interest rates are expected to be cut from 1.5% to 1% tomorrow. UK rates are also forecast to be slashed again starting at next week's MPC meeting. Some experts say 0% rates are now possible both sides of the Atlantic. Andrew Oxlade explains.

Have US rates been at 1% before?

Yes. They were cut to 1% in June 2003 in a bid to boost the economy after the invasion of Iraq. It also followed the dotcom bust of 2000-2002. Before that, the short Eisenhower recession of 1958 was the last visit to 1%.

What about UK rates?

The recent low for the bank rate was 3.5% in 2003. Before that it was after the Great Depression. Rates were pegged at 2% for 25 years from 1931. Any fall below 2% would be the lowest since the Bank of England was established in 1694.

What's happened to rates so far this year?

The US Federal Funds rate was slashed from 4.25% to 3.5% in January as the credit crunch began to turn into a financial crisis with the failure of investment bank Bear Stearns. Further cuts came through the year with a 50 basis point reduction to 1.5% on 8 October. It was part of a co-ordinated move by central banks around the globe.

UK rate cuts began in December 2007, falling from 5.75% to 5.5%. (See the full history here or in the table below). That was followed by quarter-point cuts in February and March and then the half-point cut to 4.5% early this month.

So why are rates being cut?

Central banks wanted to cut rates more aggressively throughout 2008 - they needed to increase the availability of credit and stop the crunch turning into a financial and economic crisis. But they were held back by surging inflation (see a history of inflation). This was a factor separate from the credit crunch and was driven by booming demand for oil and other commodities in Asia, mainly China.

It looks clear now that they failed to avoid the crunch rippling into a recession, at least in Europe and the US. That recession now means commodities demand has plummeted and inflation is set to evaporate. In fact, the new fear is that we may see deflation.

So now it will be a rate cut bonanza?

Absolutely. Certainly in the UK. US rates are relatively low already and about to get lower. The British bank rate at 4.5% will probably be cut by half a point at the MPC's monthly meeting next Thursday (6 November) and possibly by another quarter-point in December, to take the rate to 3.75%. Most economists expect rates to slide to between 2% and 3% by the end of 2009. Other experts have talked of a worst-case scenario of rates falling to 0%. See a full round-up of views below.

But hang on - Iceland's economy is a disaster yet it has an 18% rate

That's because the IMF demanded higher rates as part of a multi-billion rescue package. The krona, Icelandic currency, has plunged recently. Putting up rates, from 12% to 18%, helps strengthen a currency - the higher yield attracts foreign investment. That's partly why the pound has been tumbling - expectation of lower UK rates.

Will UK rates fall to 0%?

It all depends on two inter-dependent factors: recession and inflation. So far, the economy has only shrunk for one quarter. Figures are expected to show in January a further decline for the current period, confirming the UK is in recession.

In the best-case economic scenario, the recession is short and shallow. But the danger then is that cutting rates too far would unleash inflation, which is 5.2%, against a target of 2%. The MPC has been criticsed for failing to cut rates quick enough but its concern is that once inflation gets out, it's very difficult to contain. Inflation of 5%, without tight monetary policy, soon leads to 6%, 7% and upwards.

In the worst-case scenario, the recession is deep and long. Then deflation becomes the big fear. That's when the bank rate would need to come down below the 2% that most economists predict for 2009.

In March, we reported that dramatic US rate cuts could be on the cards as the slump began to hint at similarities with the Japanese banking bust of 1990.

So what happened in Japan?

Japan, the star of the post-war global economy, entered a long-term decline in 1990, frequently dipping into recession, until 2005. Both share and house prices fell over that period as Japanese workers refused to spend in the face of falling prices in the shops – a deflationary spiral.

Japanese authorities were accused of being slow to act. But by the late 1990s, the Bank of Japan had made its last roll of the fiscal dice and cut interest rates to zero. The bank rate briefly ticked up in 2000 but was swiftly returned to 0% when the dotcom bubble burst. It remained there until a brief economic recovery in 2005. That has since petered out and rates are now at 0.5% and will probably be cut again.

How will it affect mortgages and savings?

Tracker mortgage deals are linked to the BoE bank rate, following it up and down. However, lenders shrewdly add a 'collar' clause in the smallprint. For instance, Nationwide tracker mortgages will not go lower than 2.75%. Read the latest advice on mortgage trackers. Mortgages linked to the standard variable rate and the price of new fixed deals is more dependent on interbank lending, which has been artficially high throughout the credit crunch: it is what defines the credit crunch. So unless Libor falls, new mortgage pricing will not follow the bank rate down: Libor latest. The same applies for credit card and loan rates.

With savings, cash-strapped banks are still falling over themselves to secure deposits. So, rates should hold up relatively well against a falling bank rate, although they will still decline. Update on 29 October: Following requests via reader comments, This is Money's Alan O'Sullivan examines what a 0% bank rate would mean for savings rates.

Source: http://www.thisismoney.co.uk