Base rate cut again to 0.5%

In an ongoing attempt to stave off more economic misery, the Bank of England cuts its base rate from 1% to 0.5%. This strategy has run its course, so what's next?

For the sixth month in a row, the Bank of England has moved to ease borrowing pressures by reducing its base rate. The Bank's Monetary Policy Committee (MPC) halved the base rate from 1% to 0.5%. This is yet another all-time low in the Bank's 315-year history.

For the record, here's a round-up of the rate cuts:

As you can see, the base rate has fallen from 5% in October to 0.5% today. That's a drop of nine-tenths (90%) in six months, which is unheard of in the UK's financial history. Alas, while the base rate has fallen to a tenth of October's level, most lenders have failed to pass on these cuts in full to their borrowers.

Indeed, homeowners and property investors with fixed-rate mortgages -- about half of the UK's 11.67 million home loans -- won't see any benefit until their fixed rate ends and they are free to shop around. Likewise, most mortgage lenders have been slow to cut their standard variable rates (SVRs), so variable-rate deals linked to SVRs haven't come down as quickly as the base rate.

Of course, the homeowners best placed to benefit from the falling base rate are those with tracker mortgages, as these fall in line with the base rate. Then again, some of these borrowers won't enjoy this or any future rate cuts, as their contracts include a 'collar' which limits how low rates can go.

In addition, the rates on unsecured (non-mortgage) lending remain stubbornly high. Thus, credit and store cards, personal loans and overdrafts now look hugely expensive when compared with a base rate of 0.5% a year. Disgracefully, several credit-card issuers have raised their interest rates on purchases and cash withdrawals while the Bank has been slashing its base rate!

It's official: saving sucks

With the base rate within spitting distance of 0%, it is almost impossible for savers to earn a decent positive return on their cash deposits. Many savings accounts now pay less than 1% a year on credit balances, and this latest rate cut will pile even more pressure on savers. Their saving grace is that inflation (the tendency for the price of goods and services to rise over time) is falling, and could even turn negative. Thus, it may become possible for savers to earn a low-but-positive 'real' (after inflation) return on their cash.

The Building Societies Association (BSA) argued fiercely against this and further rate cuts, believing that savers have suffered enough. The BSA's members (55 building societies) are finding it difficult to attract new deposits as savings rates plunge to record lows. Without new savings deposits, societies are unable to lend freely, as they are restricted from borrowing too much via wholesale markets.

What next?

With the base rate close to 'Ground Zero', the MPC is rapidly running out of rate cuts. Therefore, it must try untested ways of easing borrowing costs. The Bank's next move will be to try something called QE, which is not the excellent BBC quiz show hosted by Stephen Fry! QE stands for 'quantitative easing', which involves turning on the money taps by increasing the money supply.

The Bank aims to start by spending £75bn on buying government gilts and corporate bonds -- IOUs which pay a fixed rate of interest. So new banknotes won't be printed; what happens is the bank buys back UK and company debt, flooding the system with new cash and improving access to credit. Nevertheless, QE will be a failure if banks hoard this extra money instead of lending it on to consumers and businesses.

The MPC is praying that quantitative easing will reduce lending pressures and bring down the cost of borrowing for consumers and businesses. Then again, when the Japanese economy went through a painful contraction, the Ministry of Finance used QE from 2001 to 2006 with little success. Another downside to QE is that it primes the inflation pump, which could mean sharply higher interest rates in future.

In summary, things look grim for the UK economy, so the Bank of England will throw in everything but the kitchen sink in a desperate attempt to avoid a long, deep depression. However, credit-starved consumers should be in no mood to go on a spending spree, so I expect to see no recovery before 2010. Regrettably, we cannot escape the biggest borrowing binge in world history via a short, shallow recession!

PS: This morning, Halifax revealed that house prices fell by an average 2.3% in February alone (and by 17.8% since February 2008), which is yet more bad news for hard-pressed homeowners.

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