BoE Cuts Interest Rates to 0.5%

 London - 6 March 2009, Finance Watch

The Bank of England on Thursday took the widely expected, but even so historic, step of slashing interest rates by 50% - down to a record low 0.5%.

But more interesting and significant is the announcement that the BoE will begin so-called quantitative easing, better known as printing money.

This is really taking the UK economy into unchartered waters and there is no doubt the world will be watching to see how this voyage of discovery turns out.

The plan is to pump an initial £75 billion of a possible £150 billion into the economy, essentially to start money flowing through the economy's veins again. It is a desperate measure by any standards and has been brought about by desperate times.

Will it lead to a huge rise in inflation?

Almost certainly not.

Of course, some inflation is the specific purpose of the exercise. Too much would be a disaster - although less so than a spiral of deflation.

The fact is that extra product, whether its money or anything else is only inflationary if there is insufficient demand. Right now the UK economy is starved of credit, especially credit to businesses, so insufficient demand and a sudden flood of cheap credit hitting the economy and causing a sudden leap in inflation seems an unlikely combination.

Wooing the fearful consumer to spend may be the hardest challenge. Unemployment is shooting up and consumer confidence has fallen off a cliff. Who will borrow and spend if they genuinely fear they will lose their job?

Monitoring the effects of the cash injection will be key and the bank will be ready to reverse the cash injection if needed. The real worry is that this is pretty much the last bullet in the bank's gun - apart from pumping in more money.

Quite how the new money will be injected into the economy isn't yet clear, although it has been widely speculated previously that the BoE will buy the UK government's debt in the form of gilts from banks and other institutions. That liquidity, it is hoped, will then be lent out by those same banks and institutions and the wheels of the credit machine will gradually groan back into life again.

So far in this crisis, where the UK has gone first, others have tended to follow. The eurozone cannot take the measures the BoE has announced today, perhaps this has been the reason it has been slower to cut rates: it needs some ammunition in reserve.

What is clear, or at least what is becoming clearer, is that rate cuts alone are not going to persuade fearful banks to return to business that is anything like normal. Other measures are needed and the UK's BoE has taken the bold step of deploying them.