Is Britain heading for a 0% base rate?

Well, if you didn’t think we were already in trouble, you know all about it now.

The Bank of England’s 1.5% rate cut sends a very clear signal to the markets. The UK’s in recession and it’s not going to be a nice “in and out” recession – it’s going to be the long and nasty variety. As the Monetary Policy Committee put it: “There has been a very marked deterioration in the outlook for economic activity at home and abroad.”

Stock market investors clearly agreed. A massive cut like this would, in the recent past, have sent markets soaring. But instead the FTSE 100 tanked, falling more than 250 points.

Markets are right to be worried. The Bank is now throwing all it has at the downturn. But what if it’s not enough?

Why the bank felt it had to suprise the money markets

I wrote yesterday about why the huge rate cut won’t necessarily mean a similar-sized fall in mortgage and loan rates (see: Will the Bank of England’s rate cut help your wallet?). The recession itself is making lending riskier, and that means that banks and other lenders need to make a better profit on each loan to tempt them to take that risk.

This is no doubt one of the main reasons why the cut was so large. The Bank felt it had to surprise the money markets, who would already have been pricing in a move of up to 1%. We’ll see over the coming days how well the move has worked.

The worrying aspect for the Bank, of course, is that there isn’t much further to go. As Bloomberg puts it this morning, “the age of free money may be at hand.”

Interest rates across the world are well below headline inflation measures. Our 3% rate compares with a 5.2% annual consumer price index inflation rate. That is set to come down – the price of oil took another dive yesterday, for example, to a 21-month low – but it’s certainly not good news for savers. And the same thing is happening in America, Japan, and even traditionally inflation-averse Europe.

Will making it unattractive to save really stimulate the economy?

That’s deliberate of course. One way, in theory, to stimulate an economy is to make it unattractive to save. It worked very well during the boom of course, as it always does.

But the trouble is, companies and consumers may well decide they’d still rather repair their balance sheets than spend their money. This makes perfect sense. If you are heading into a recession, then whether you are a business or a private individual, you will fear for your money. Company profits fall, people get scared for their jobs.

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So money in your hand suddenly becomes worth a lot more than the promise of an uncertain income in the future. So just as banks are seeking a bigger return on lending, so companies will need stronger reasons for investing in new staff or new capital, and consumers will be more careful with the purse strings. The riskier the economic environment becomes, the more incentive you need to part with your cash.

If your washing machine breaks down, you’ll probably still replace it. But that new TV you were wanting for Christmas, well, it can wait until next year. Two years ago, you might not have thought twice, but now you’re worried that your bank might go bust, or your employer might start laying people off.

When people are feeling like this, it doesn’t matter how cheap borrowing becomes, because the security and liquidity premium on cash in the hand has become so high. At this point, central banks are just “pushing on a string” by cutting rates.

The US looks more and more like Japan

If you think this is overly negative, then just look at the US. The Federal Reserve acted much more quickly than the Bank of England (as Mervyn King’s critics have been quick to point out) but it hasn’t done them any good.

That’s why John Maynard Keynes recommended government stimulus. The public sector spends money because no one else is prepared to. The trouble with this as a solution is that all public money is ultimately taken from the private sector. You either pay for it now, through taxes; or you (or your children) pay for it in the future, when the government needs to repay its borrowings.

So what can be done? Already the Federal Reserve has reached desperation point. According to the FT, it seems as though the Fed is starting to look to the Japanese experience of “quantitative easing” for other ways to pump money into the economy.

I’ll have more on this in a future Money Morning. But suffice to say, if policymakers are still looking towards Japan for solutions we should all be worried. Zero interest rates and massive government spending have so far earned Japan nearly two decades of economic stagnation.

Some argue that without these policies, Japan’s collapse would have been even more damaging. But if that’s the best-case outcome for what Britain and the US are about to go through, I’d hate to see the worst.

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