3% Base Rate - What Does It Mean?

The Bank of England has cut the base rate to 3%. It's already affecting the mortgage market. What else does it mean for Fools?

Today's base rate cut from 4.5% to 3% is stunning. I wasn't expecting such a big move and I wasn't alone. In a Bloomberg survey of 60 economists, nobody predicted such a large cut.

You might be surprised that the base rate has fallen so low when inflation is on the up and has hit 5.2%. Normally, you'd expect a base rate hike to slow down rising prices. But the inflation outlook for 2009 looks very different and the Bank of England's Monetary Policy Committee (MPC) is looking ahead.

We're entering a serious recession and that means lower demand for goods and services, which normally means lower inflation. Indeed, the global crisis is so serious, we can't rule out deflation (falling prices). I suspect that it's the fear of deflation which is driving the MPC.

After all, the MPC is tasked with keeping inflation between 1 and 3%, and going below 1% is just as embarrassing as going over 3%. In fact, I'd be very worried if inflation fell below 1% as it would suggest to me that we're about to experience a full-blown economic slump rather than `just' a recession.

What about mortgages?

Tracker mortgages fall when the base rate falls. This is good news for existing borrowers, who will see a 1.5% drop in their mortgage rate this month - knocking thousands of pounds off the average borrowers' yearly payments.

What about new borrowers? Is it still possible to get a decent tracker?

Sadly, several lenders have already announced that they've withdrawn their tracker mortgages for new borrowers. These lenders include:

Skipton Building Society
Woolwich
Cheltenham & Gloucester
Lloyds TSB
The Mortgage Works (a subsidiary of Nationwide)
Alliance & Leicester
Nationwide
Abbey

Some of these lenders may return with new tracker deals next week. But if they do, the margin over the base rate could be significantly higher. That would wipe out much of the base rate cut.

And there is even more bad news. Nationwide and Abbey have announced they are pulling all their tracker deals and do not plan to replace their tracker ranges at all. Other lenders may follow suit, meaning that, not only will trackers be more expensive, there will be fewer trackers available to choose from.

On the plus side, Lloyds TSB and Cheltenham & Gloucester have announced they will pass on the full 1.5% cut to borrowers on their Standard Variable Rate (SVR). Their SVR will be just 5% from December 1^st.

We don't know whether other lenders will follow Lloyds TSB's lead. Don't assume that they'll all cut by the full 1.5%. In the current climate, Libor still has a big impact on mortgage rates and Libor rates haven't fallen by anything like 1.5% so far.

Rates for Fixed Rate Mortgages should fall in the next few weeks (and months), so it's probably best to hold off on taking up a fixed-rate deal unless you absolutely have to.

Savings

Sadly, savings rates will inevitably fall. If you rush, you could lock in your savings at a great rate on a fixed rate bond for 12 months. ICICI is still offering 6.1% for a year on its fixed rate bond.

My Foolish friend, Jane Baker, is nervous about fixed bonds but I'm more upbeat. After all, even in the worst case scenario, you'll still get your money back from the government in the end - as long as you don't save more than £50,000 with banks that hold one banking licence.

What's to come?

Clearly the boffins at the Bank of England are very worried. And that worries me. But I suspect they've done the right thing. It will be interesting to see how much further the base rate will fall over the next few months.