How low can they go?

As the UK’s service sector shows signs of weakening, unemployment rises and households find it more difficult to pay bills and mortgages, home repossessions are expected to rise. But will even a 1% cut in base rate be enough to alleviate the downward pressure in the economy?

One possible problem is the extent to which a lower base rate will feed into lower mortgage payments. Many households (58% in August 2008) are still on fixed deals, meaning their monthly repayments will not change. And some tracker mortgages are ‘collared’ (there is a minimum interest rate paid, regardless of base rate) and homeowners will be checking the small print today to ensure they can benefit fully from any cut in base rate. There is evidence, too, that new tracker deals coming onto the market are less generous than in the past - and this will typically affect those households finding things hardest at present, for example those with low deposits or customers unwilling or unable to find a large ‘set up’ fee.

Another issue is the liquidity trap - a theory proposed by man-of-the-moment (after many years where his ideas were in the wilderness), John Maynard Keynes. Put simply, the lower the base rate, the fewer opportunities the Bank of England has to make further cuts to stimulate spending (consumption and investment). Also, during a period of deep recession (or ‘dark depression’ as a year 12 student put it in an essay he wrote for me recently!) households and firms will not want to spend and may even choose to save when interest rates are falling.

So even for households where the cut in base rate is passed on in full, how much of this windfall will they actually spend? And how much of it will they save instead?