Economists say extraordinary times will take rates to record low

Economists predicted benchmark UK interest rates would plummet to an all-time low of 1% amid "extraordinary" economic circumstances, after the Bank of England astounded all by slashing them from 4.5% to 3% yesterday.

The one-and-a-half-point cut was, excluding the intraday gyrations around the point sterling exited the European Exchange Rate Mechanism in 1992, the biggest single reduction since 1981 and took benchmark UK rates to their lowest level since January 1955. Even the most extreme projections ahead of yesterday's meeting of the Bank's Monetary Policy Committee were for a cut of a full-point, amid mounting fears of a deep and prolonged recession, so the MPC move had plenty of dramatic impact.

Benchmark UK rates have never fallen below 2% since Bank of England records began in 1694. They were last at 2% in the period from 1939 to 1951.

The UK's FTSE-100 index of leading shares clawed back some of its earlier losses in the immediate wake of the MPC's announcement at noon but soon headed south again and to even poorer levels than before the rate call, as traders fretted about the gravity of the economic situation.

The Footsie finished 258.32 points lower at 4272.41, with weakness on Wall Street exacerbating its troubles.

Ross Walker, UK economist at Royal Bank of Scotland, seized upon the fact that the Bank of England yesterday cited a "substantial risk of undershooting the (2%) inflation target" at prevailing market interest rates. Even before yesterday's radical move, financial markets were pricing in very deep cuts in UK base rates.

Referring to the Bank of England's statement yesterday, Walker said: "It was a huge surprise not only the 150-basis-point cut but also the fact that, despite that cut and despite their having factored into their forecasts all the additional rate-cut expectations that the market was pricing in, they still concluded in their statement that there was a substantial risk of an undershoot in inflation."

Interpreting the Bank's statement, he added: "They have recognised rates were at too high a level - they were behind the curve. But getting rates to where they need to be, this is still a work-in-progress. We are not there yet. The implications are we could get another sizeable cut in December."

Asked how far UK base rates might fall ultimately, Walker replied: "I think we are heading for something like one to one-and-a-half per cent, sort of US Fed-style territory."

Jonathan Loynes, chief European economist at consultancy Capital Economics, is projecting UK base rates will fall to "1% or even lower".

He said: "That forecast is on the basis we think that is what will need to happen and the MPC will realise that. Essentially, our economy is in as bad a position as the US economy, therefore our interest rates should be as low as those in the US, particularly when you take into account the credit crunch, which suggests interest rates need to go lower than normal levels."

The US central bank cut its benchmark Fed funds rate by a half-point to 1% on October 29.

Loynes highlighted the fact that the MPC had cut UK base rates by one-third yesterday, in reducing them from 4.5% to 3%. He said: "To get a one-and-a-half-point move when they are only at 4.5% in the first place is quite extraordinary but these are extraordinary times."

The European Central Bank yesterday cut benchmark interest rates in the 15-nation eurozone but less dramatically than the MPC.

The ECB reduced eurozone rates from 3.75% to a two-year low of 3.25%. It signalled it could cut again next month.

Announcing yesterday's rate cut, the Bank of England said: "In recent weeks, the risks to inflation have shifted decisively to the downside. As a consequence, the committee has revised down its projected outlook for inflation which, at prevailing market interest rates, contains a substantial risk of undershooting the inflation target."

And, highlighting the bleak outlook for the economy, the Bank declared: "In the United Kingdom, output fell sharply (by 0.5%) in the third quarter. Business surveys and reports by the Bank's regional agents point to continued severe contraction in the near term. Consumer spending has faltered in the face of a squeeze on household budgets and tighter credit. Residential investment has fallen sharply and the prospects for business investment have weakened. Economic conditions have also deteriorated in the UK's main export markets."

It noted the "global banking system has experienced its most serious disruption for almost a century", as it emphasised continuing troubles in credit markets. The global credit crisis intensified dramatically after news on September 15 that US investment bank Lehman Brothers had collapsed.

Further dire economic news came yesterday when Halifax said the average UK house price dropped by a seasonally-adjusted 2.2% in October to £168,176. This left it 14.9% lower than in October 2007 - the worst year-on-year fall since comparable records began in 1983.

The International Mone-tary Fund yesterday predicted the world's developed country economies would in 2009 show their first full-year contraction since the Second World War. It is predicting contraction of 0.3% for these economies, which include those of Europe, the United States, and Japan, only a month after it forecast expansion of 0.5%.

Referring to the MPC's action on rates to date, Walker said: "They have dragged their feet a little bit."

On yesterday's move, he said: "I think there was a sense of relief. If nothing else, I think it is the assurance they are finally getting on top of it."

Although welcoming the MPC's cut yesterday, British Chambers of Commerce economic adviser David Kern said: "We believe the MPC should move much more steadily and deliberately and avoid too many lurches towards emergency measures.

"Emergency measures have the undesirable effect of unsettling the markets and undermine confidence.

Using up all their bullets prematurely will leave the MPC with little scope to inject confidence through continued rate cuts when the recession deepens."