Interest rates are no longer the key story

The Bank of England has cut policy interest rates to 1.5% (a reduction of 0.5%) taking them to their lowest level in the long history of the Old Lady of Threadneedle Street. Several mortgage lenders have announced whole or partial reductions in standard variable interest rates on mortgages but the majority of lenders will be reviewing carefully whether they should bring their borrowing rates down ... the reason is simple but really important ..... the debate on interest rates is moving on.

The Bank of England has moved aggressively on interest rates in a bid to provide some relief and support to hard-pressed mortgage payers and businesses with loans to service. At 1.5 per cent, the base rate of interest cannot fall much further. Indeed there is a serious risk that ultra-low interest rates will undermine the ability of banks to re-capitalilise by attracting a fresh flow of deposits from savers.

Building societies for example now face a dilemma. Lowering the rates they charge on mortgages might make financing a housing loan more affordable and perhaps help to stabilise the steep decline in property prices. But, as mutual funds, building societies also have a responsibility to their depositors many thousands of whom have been stung badly by a dramatic decline in monthly income from savings accounts.

The apparent inequity of responsible savers ultimately paying the price for the profligate borrowing during the last decade has not been lost on those newspapers that purport to represent the views of middle England. And they have a point. 1.68% is the average interest rate for savers in all bank and building society instant access accounts in the UK - a rate well below the current official rate of inflation implying a negative real return for those who never succumbed to the temptation to borrow beyond their means.

LIBOR is down to 2.5%, the UK base rate is close to the floor and sterling is low (and perhaps stabilising against the Euro and the Dollar). But the credit markets remain frozen not least the market for property loans and until the lenders have a sufficient capital base and the confidence to lend again, the risks of a deflationary depression remain high. Fiscal policy is now the best option to stimulate aggregate demand .... but the best approach within the fiscal policy domain is another story!

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Base_Rates_Jan_09.ppt