Will the medicine work?

The Bank of England's reduction in base rates from 4.5% to 3.0% took everyone by surprise today. It is not possible to understate the significance of this move - at a stroke, the notional cost of borrowing has been reduced by a third.

The last downward move in interest rate in excess of this (excluding the slight hiccup during Black Wednesday) was the 2% reduction in 1981 from 14% to 12%, but in terms of a percentage reduction, the cost of borrowing fell by only a seventh.

The Bank is tasked with setting interest rates to target inflation. It has no remit to target growth. Therefore, one must conclude that the Bank believes there is a very serious risk of it undershooting its 2% inflation target in the medium term - deflation. Japan went through an unpleasant period of deflation in the 1990s, and the Bank of Japan reduced interest rates to zero, but it took over a decade to work.

Deflation in economies is a problem because when prices are falling simply because consumers have no desire to buy, this leads to a vicious cycle. Consumers postpone spending because they believe that prices will fall farther. The effect on businesses is that they then cannot sell goods and make a profit. In response, companies then reduce production and lay off workers, which in turn leads to even lower demand for goods and even lower prices. Businesses struggling to repay borrowing ultimately impact the banks, who then become more risk averse and have less money to loan, further restricting the supply of money.

House prices are currently falling in the UK as there is a shortage of credit to finance the purchase of assets. And of course, who wants to buy a house when it is probably going to be cheaper tomorrow. A lack of demand then causes further house price falls, and the spiral continues...


So I suppose the question is, will the interest rate cut help boost the economy and avoid recession, or are we in for a period of deflation, recession and stagnant growth?

For the homeowner, on an average £150,000 mortgage, the cut for those on a tracker deal (around 40% of mortgage holders) represents about £135 a month. For the 10% on standard variable rates, it will be ultimately up to the individual bank or building society what they do with their rates. For the other 50% or so on fixed deals, this will make no difference to their monthly repayments. However, this is a sizeable

Lloyds TSB have already announced that they will be passing on the full 1.5% interest rate cut to those on the standard variable rate. Given the taxpayer ownership of HBOS and RBS, I think it would be inconceivable for either of these institutions to not pass on the full reduction. There would be public outcry and I would suspect the Government would find continuing its hands-off management of the banks unsustainable.

HBOS is the biggest mortgage lender in the UK, and Lloyds TSB and RBS, which owns Natwest, together would make up a sizeable proportion of the UK mortgage market. Competitive pressures would then bear down on the other private institutions and they would probably all be forced to cut rates.

So I believe that the banks will pass on these savings and by my rough calculation, this should mean 7.5m households will benefit by, on average £1,600 per year. Or - put it this way - it puts £12bn back in consumers' pockets to spend. This is a considerable stimulus. What is unknown is whether the public will spend this money, or fearful for their jobs, decide to save it...


For businesses, consumers with extra money should provide a boost to their sales. The direct impact of the base rate cut on business is less certain. What is stifling companies is the lack of available credit more than the absolute interest rate. And while rates may fall for business in the short term, when they come to renegotiate their finance, they may find that the new rates are higher.


It is probably too late to avoid a recession, but the Bank's actions have probably averted a depression.