AS interest rates plummet to their lowest level in 53 years, is it enough to avoid a prolonged recession?
IN THE days leading up to last Thursday's unexpected slashing of UK interest rates, Alistair Darling and Mervyn King would have been burning the midnight oil debating what can be done, if anything, to avoid a protracted recession.
In an unpreceden
ted move the Bank of England's Monetary Policy Committee (MPC) members transformed themselves from hawks to doves when they cut rates by 1.5% to 3% - the lowest since January 1955. Chancellor Darling and King, the Bank of England governor, had finally bowed to pressure to slash the cost of borrowing to fend off a deep economic slump.
That pressure was coming from one of the most profile business figures in the UK, none other than Tesco chief executive Terry Leahy.
Leahy, who has been openly critical of the MPC's cautious approach to rate decisions in the past, met with King behind closed doors in the days before the aggressive reduction was announced and told him in no uncertain terms what action he wanted taken.
Leahy is a hard man to ignore given his position as one of Gordon Brown's committee of business leaders and the fact his Tesco empire accounts for more than 30% of the UK grocery market. He also has a stronger interest more than ever in the financial sector with Tesco hoping to have its own banking licence within two years.
Once King had convinced the other members of the MPC to agree to a 1.5% cut, it was over to Darling to persuade lenders to pass it onto their hard-pressed borrowers. Banking chiefs were called to Downing Street on Friday morning and by the end of the week RBS, HBOS, Lloyds TSB, Abbey and Nationwide had all agreed to the full reduction.
The MPC's decision is seen by commentators as a clear sign that the threat of inflation is waning and the risk of recession is growing.
Last month King uttered the dreaded "r" word and other commentators followed suit. The talk since has been of "when" not "if" the UK will be in a technical recession and just how severe it will be.
But will the MPC's move be enough to get the economy back on track? If not, just how many more cuts are on the cards to curb the slump?
One of the key factors behind the MPC's drastic cut was the consensus that inflation has become less of a threat in recent weeks.
In its statement, the MPC made it clear that it had taken into account slowing inflation, on the back of the declining impact of retail energy and food prices on household budgets.
It said: "The past two months have seen a large downward shift in the prospects for inflation in the UK. There has been a marked deterioration in the outlook for economic activity at home and abroad...The Committee therefore judged a significant reduction in Bank rate was necessary now to meet the 2% target for CPI inflation in the medium term."
Charles Davis, economist with the Centre for Economics and Business Research, says: "As Mervyn King stated last month, the risks to the inflation outlook have shifted 'decisively to the downside'. In English, this inflationary episode is expected to disappear as quickly as it arrived."
Davis explains that global commodity prices halving since their peak in July, wage growth subdued due to the fastest rise in unemployment since the early 1990s recession, and weak growth in nominal demand linked to the credit crunch have combined to "make concerns over rising inflation seem past their sell-by date".
All eyes will now turn to the BoE's inflation report, due out on Wednesday, which according to Andrew Milligan, head of global strategy at Standard Life Investments, will justify the larger than predicted rate cut.
He says: "The report will give investors full and detailed information about its views on the depth and extent of the UK recession and how far inflation might fall in 2009."
With inflation now forecast to remain at 2% in the medium term, Tom Vosa, head of market economics UK for NAB Capital, does not expect the MPC to make further cuts next month or in January while it waits for last week's cut to make an impact.
The danger is the dramatic action by the MPC may still be too little too late, as it happened on the same day that new figures highlighted the economy's slide towards recession.
Among the flurry of bad news last Thursday was a report from the Office for National Statistics that construction orders had fallen 20% in September, year on year, to their lowest level since late 2003.
Meanwhile, new car registrations plummeted 23% last month, their sharpest drop since 1992. And the Halifax house price index revealed that house prices have dropped 14.9% in the last 12 months, making both the scale and the speed of the fall in house prices far greater than the early 1990s.
The decision also came as a report by the International Monetary Fund (IMF) sounded alarm bells for the UK economy. The IMF forecast that the UK would be the worst-performing major advanced economy next year. It warned that Britain's economy will shrink by 1.3% in 2009, the first full year of decline since 1991.
Although the IMF downgraded its outlook for all the major economies, it was Britain that stood out as coming at the bottom of the pile. Its stark prediction undermines claims by Gordon Brown and Alistair Darling that Britain is better placed than some of its European counterparts to weather the economic storm that is brewing.
Clearly the MPC was taking signs of further deterioration in the economy into consideration when voting on what to do with rates. Its statement pointed to deteriorating economic conditions in the UK and overseas.
However, to have the desired effect of kick-starting the economy, including the beleaguered housing market, banks will have to reduce their rates for borrowers. The London Interbank Offered Rate (Libor) – the rate of interest at which institutions borrow funds from each other – will also have to move downwards.
"As we have been saying for some time, the key is how 'effective' interest rates respond – those that are felt by the consumer and companies; in other words how short-term Libor, medium-term mortgage rates and longer-term corporate bond yields react to the Bank's move," says Milligan. "These need to come down, quickly and sharply, to help stimulate the UK economy."
Davis believes that last week's "bold" action should be good news for borrowers and that while interbank spreads remain historically elevated, banks should be able to pass on a noticeable amount of the cut.
However, Vosa warns that the impact on the spread between three-month Libor and Bank base rate may be less than hoped for if markets believe the MPC is reaching the end of the "easing" process after slashing rates by such a large margin.
The other issue is that on the day the base rate was cut, only two lenders – Lloyds TSB and Abbey – reduced their rates by the full 1.5%. On Friday HBOS, Royal Bank of Scotland group and Nationwide Building Society followed suit.
Trade body Homes for Scotland warned the reduction must be quickly passed on to housebuyers. Its chief executive Jonathan Fair says: "Lenders must be persuaded to pass this substantial reduction on at the earliest opportunity. Even more importantly, it is vital we see the Libor rate gap close if businesses and consumers are to benefit from further liquidity being injected into the economy and borrowing becoming more affordable."
The Government has stepped up the pressure on banks to pass the cuts on to customers. Yvette Cooper, the Treasury chief secretary, said the banks that shared a £37bn injection of taxpayers' money had signed up to certain conditions, including lending at competitive rates.
But Alistair Darling admitted there are limits to what the Government can do. He said: "I believe it is imperative that banks realise they have got to play their part in helping businesses and helping people. Banks have to decide on the individual case, the terms and conditions on which they lend. That's what people can expect. The Government can't help."
Many commentators do not think the MPC's action will be enough to steer the UK away from a full-blown recession. Richard Dingwall-Smith, chief economist, Scottish Widows Investment Partnership, says: "The UK economy appears to have hit an air pocket in the last couple of months, with activity falling sharply and with the labour market starting to weaken significantly. It is now likely that UK activity will contract further over the next couple of quarters as the credit crunch triggers weakness in consumer spending, falls in capital spending and a downward correction of inventories. A significant recession appears inevitable."
Another concern is that the Bank's shock move shows the economy is in an even worse state than most commentators thought. Investors took fright and the FTSE 100 closed down 258.32 points at 4,272 on Thursday.
Given the MPC's signal that it is willing to take drastic action, most commentators are now revising their predictions about how low rates will go. Paul Niven, head of asset allocation at F&C, is confident that further material cuts will be forthcoming in both the UK and Euroland, with expectations for 2% or lower now entrenched in market expectations.
Michael Saunders of Citi European Economics says that before last week's move he was expecting the MPC to cut rates to 2% by mid-2009. In practice, he says it now seems likely that rates will get to that level by the end of the first quarter of next year or even sooner. "Whether the floor in rates is 2%, 1% or even zero, the UK is likely to get there fairly soon, provided inflation expectations remain well behaved," he says.
But the burning question commentators cannot answer yet is whether the country can be saved from a lengthy recession even if rates hit zero.
The state of play in 1955THE last time interest rates were as low as 3% was January 1955 when Winston Churchill was Prime Minister, for the second time, and Queen Elizabeth II had only been on the throne for two years.
The world was clearly a very different place. In 1955 a loaf of bread cost 2.5p (6d in old money), compared with its current price tag of £1.20, and a pint of milk cost 2p (5d), rather than 45p.
A number of landmark events occurred across the globe in 1955.
In Britain, Churchill stepped down as Prime Minister in April and handed over to Anthony Eden.
Further afield, Ray Kroc opened the first McDonald's in Des Plaines, Illinois, West Germany became a sovereign state and joined Nato and the Warsaw Pact was formed.
Looking at the British economy, 264,500 of the population were claming unemployment benefit and the average house price stood at £1,937.
Allowing for inflation, that is roughly the same as £38,000 in today's prices. However, given the relatively low level of home ownership, house prices did not provoke the same level of debate as they do at present.
Just over half the population owned a home in 1955, compared with 66% today.
The moves in the two years running up to 1955 by the Government to simulate growth and boost the housing market by cutting interest rates worked and the year proved to be a turning point for the British economy.
It remains to be seen whether the same strategy will have the desired effect this time round.
