Exceptional circumstances require exceptional measures and I expect today’s "emergency" 0.5% interest rate cut to the first of a series of moves taking rates down to the exceptionally low level of 2.5%. In fact, they may have to fall to, or below, their all-time low of 2%.

The fact that the Monetary Policy Committee was prepared to cut interest rates by a full half point – from 5% to 4.5% – 24 hours ahead of the normal scheduled meeting underlines the seriousness of the problems facing the banking sector and the real economy. This was part of coordinated action on an unprecedented scale that saw the US Federal Reserve, the ECB, the Bank of Canada, the Swiss National Bank, the Swedish Riksbank and the Bank of China all cut their interest rates.

No doubt the move will lead to some questions over whether the MPC is putting the stability of the global financial sector ahead of its domestic inflation-targeting objectives. But the Committee stressed in the statement accompanying the move that the economic data released over the last month "indicate that the outlook for economic activity in the UK has deteriorated substantially, reflecting a sharp monetary contraction."

Against that background, the MPC’s concerns over the UK inflation outlook are easing rapidly. Although it acknowledged that there is still a danger that above-target inflation raises inflation expectations further, it concluded that the balance of risks to inflation has shifted decisively to the downside. I have been forecasting for some time that inflation will drop comfortably below its 2% target by the end of next year and now the MPC appears to be moving in that direction.

Coupled with this morning’s announcement of the Government’s plans to inject £50bn of capital into the UK’s largest banks, it is to be hoped that today’s move will provide at least some short-term support to the financial markets and banking sector.

But on its own, the move will do little to improve the outlook for the wider economy. After all, at 4.5%, interest rates are probably still at neutral or even restrictive levels, particularly when the high level of market and mortgage rates are taken into account. In other words, in order to prevent a recession developing into a depression, the MPC will have to cut rates much further.

I expect that rates will fall again next month, and perhaps in December too. After all, during the global financial crisis in 1998, the MPC cut interest rates in five consecutive months, including three moves of 50bps. Accordingly, history shows that when the whole financial system is at risk of falling apart and the economy is heading for a full-blown slump, the MPC tends to respond.

In short, interest rates are set to fall to 2.5% next year, their lowest level since 1951. But that will still not prevent the UK from enduring a recession akin to that of the early 1990s.

ends

Notes for editors
This press release has been prepared by Roger Bootle, Economic Adviser to Deloitte. If you have any questions regarding the views in it, please contact Roger Bootle directly on 07887 955 875 or 020 7823 5000 or via email on business@capitaleconomics.com.

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