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dramatic interest rate cut takes market by surprise

The Bank of England and other central banks have operated with unprecedented global co-ordination to announce a cut in base rates of half a per cent. The Bank of England base rate has now fallen to 4.5% - the lowest level for two years.

An emergency meeting of the Bank of England Monetary Policy Committee was held on Wednesday 8 October, on the same day as scheduled, but earlier in the day. Following this, a joint announcement was made with the US Federal Reserve, the European Central Bank and other central banks in Japan, Canada, Switzerland and Sweden. All cut their base rates by half a per cent, while China cut its base rate by 0.27%.

Deflation worry

The Bank of England hinted that a cut was necessary to avoid deflation, or at least inflation falling below its 2% target. In August, inflation rose to 4.7%, but the Bank said that inflation was unlikely to continue rising with energy prices flattening out and spare capacity in the economy likely to bring other prices down.

In a statement, the Bank said: "In the United Kingdom, the supply of credit to households and businesses is clearly tightening further as banks seek to adjust their balance sheets. The [Monetary Policy] Committee noted that cuts in official interest rates could not be expected to resolve the current problems in financial markets and that a significant increase in the capital of the banking sector would be required."

It welcomed steps taken earlier the same day by the UK Government to inject extra capital and liquidity into the banking sector.

A positive response

Mortgage lenders gave the move a positive response. CML director-general Michael Coogan said: "[The] package of bank funding and capital measures is further strengthened by this rate cut. Not only are the tripartite authorities now pulling together decisively to address domestic confidence, but international central bankers are also collaborating much more effectively on their position. All this decisive action augurs well for an improving market situation looking ahead, even though no one is pretending the tough times are over yet."

Housing market support

Adrian Coles, director-general of the Building Societies Association said that the interest rate was necessary given the weak outlook for the economy, the fall in house prices and the reality of stalled activity in the housing market.

"This reduction in bank rate will provide some support to the housing market because it will help those borrowers on variable rates," said Mr Coles. "However, new fixed rate deals and those linked to money market rates will not necessarily fall because they are determined in the money markets rather than directly by the bank rate.

"Although today’s news will clearly help those with repayment difficulties, borrowers who still think they might encounter problems repaying their mortgage should get in touch with their lender as soon as possible. At their building society, borrowers will find a sympathetic response and help in getting their finances sorted."

Mortgage pricing starts to fall

Darren Cook of analysts MoneyFacts said that some of the major lenders responded immediately with rate cuts on mortgage products. "We have seen that banks look like passing on the full 0.5%, which is good news," he said. Cook suggested that the banks had probably agreed to do so as part of their negotiations with the Government to inject greater liquidity and capital into the sector.

Some commentators have predicted that credit card and other unsecured lending will now become more expensive, because it does not apparently come within the agreement reached between the Government and banks. But Cook said he expected unsecured lending to remain broadly on existing terms, though he thought it was unlikely that banks would fully pass on the rate cut on unsecured lending.

  • 08 October 2008
    by Paul Gosling