The base rate cut: why it's in your interest

The Bank of England's recent interest rate cut should be good news for the economy. Will Hodges looks at the reasons why...

In Focus: Interest rates

Economics might be known as the most dismal of sciences but it is also revealing itself to be one of the least predictable. On the morning of the much anticipated decision by the Monetary Policy Committee whether to lower the Bank of England's base rate, a leading financial newspaper ran a poll amongst leading economists as to how severe the cut should be. The more conservative advocated a 0.5% cut; others varied between 75 and 100 basis points; one expert even went as far as a radical 125 points. Few could have predicted the actual outcome later that day - a 1.5% cut, the largest since 1981 which brought the base rate down to 3%, its lowest level since 1954. The move illustrates the severity of Britain's current economic predicament - economists have predicted that the UK will have the lowest growth in the developed world during 2009: -1.0%. In cutting interest rates to such a degree it is hoped that an even deeper, longer lasting recession will be averted.

So, what are interest rates exactly and why do they matter?

The BoE interest rate sets the bottom level for the cost at which businesses and individuals can borrow money. The lower the rate, the easier it is for banks to borrow money from the Bank of England, and (it is hoped) that they will in turn be able to pass on this low cost of borrowing to businesses and the man on the street. Lower borrowing means more incentive for companies to grow their business or for institutions and individuals to invest in companies rather than putting their money into savings. Furthermore, a low base rate has an affect on the strength of the Pound as investors have less incentive to invest in sterling and government bonds, bringing the currency downwards in relation to other denominations such as the Dollar and the Euro. Though there are downsides to having a weak currency - imports become more expensive and people's salaries and savings are worth less in world terms - the effect on businesses is good as demand for British goods and services are more attractive to foreign buyers, boosting exports. The problem over the last few months is that despite the base rate being relatively low in historical terms, there has been a discrepancy between this rate and the rate at which banks are willing to lend to each other and to customers, known as the LIBOR rate. Ideally the two would be evenly matched, however, despite banks yielding to pressure by the government with a 1% cut, the Libor rate still stands at just under 4.5%, almost 1.5% above the base rate. Banks and mortgage lenders are reluctant to pass on low rates to borrowers, wary of the risk of lending out money long-term, a, because of the risk that they will not get their money back, and b, because they themselves are finding it difficult to borrow short-term from other banks. Following the 1% cut in Libor rates, Chancellor of the Exchequer, Alistair Darling, summoned the leaders of the UK's major banks and mortgage houses to Downing Street to demand that they pass on the BoE's base rate cuts to consumers. So far, however, the majority have been reluctant to do so. ****

Aiming Lower

It is unlikely, however, that the MPC will stop there. Most economists are predicting further cuts over the next 12 months with speculation that the rate will be taken below its lowest ever level of 2%, perhaps even equalling that of the current 1% level of the Federal Funds Rate, the US's equivalent. Such action would be unprecedented but the fact that such a drop is being seriously considered highlights the threat to the British economy over the next few months. The ability to raise or lower interest rates in the major tool available to the Bank of England in steering the economy. If such drastic action doesn't work then there will be few other options available to Governor Mervyn King and his colleagues in pulling Britain out of recession. Lets hope it proves to be enough. ****