The Race to Zero

The Bank of England slashes interest rates to their lowest level since 1955; the ECB cuts too.

It is hard to spring a surprise when everyone is expecting one but the Bank of England has managed it. Its monetary-policy committee slashed the bank’s benchmark interest rate by 1.5 percentage points, to 3 percent, on Thursday November 6th. A bold cut of one percentage point had been widely touted, though many had expected something less extravagant. That the cut was so much deeper, the biggest since the central bank took charge of interest-rate decisions in 1997, reflects alarm about the economy’s sudden deterioration. Interest rates in Britain are now at their lowest level since 1955. Less than a hour later, the European Central Bank (ECB) cut its key interest rate too, but by only half a percentage point, to 3.25%. On the same day the IMF revised its economic outlook: it now reckons that Britain’s economy will shrink by 1.3 percent in 2009, and that of the euro area by 0.5 percent — a far gloomier assessment than a forecast made just a month ago.

In an extended statement, the Bank of England gave warning that the economy is set for a “severe contraction” in the coming months. Though consumer-price inflation, at 5.2 percent, is uncomfortably high, the bank reckons that the collapse in commodity prices and the prospect of weaker growth means there is now a “substantial risk” that inflation will fall below its 2 percent target.

By its usually cautious standards, the ECB’s action — the second half-point cut in the space of a month — was nearly as dramatic. Set against the Bank of England’s derring-do, however, the Frankfurt-based central bank looks like it is not taking the recent sea-change seriously enough. “The world has changed but the ECB seems not to have realised it,”according to Aurelio Maccario, an economist at UniCredit, an Italian bank. For the first time in the ECB’s ten-year history, its main policy rate is above that of the Bank of England.

The drastic action was justified by grim economic data. Figures released just before the ECB’s decision showed that German factory orders had plunged by 8 percent in September, the biggest one-month decline on record, indicating that firms worldwide are slashing their investment spending. The purchasing-managers’ index, a reliable guide to euro-area activity, released earlier in the week, dived from 46.9 to 43.6, the weakest-ever showing for the ten-year-old survey. And the European Commission’s measure of economic sentiment slumped to a 15-year low in October.

Europe’s consumers, never free-spending, are tightening their purse strings. Economists at Barclays Capital reckon that sales of new cars fell in October to the lowest level since 1997, after adjustment for seasonal factors. Three luxury carmakers, BMW, Porsche and Daimler, have all said that weak sales mean they will try to trim output by extending their usual Christmas shutdown.

economist zero chart

Britain’s economy looks worse. GDP fell at an annualised rate of 2 percent in the third quarter. Factory output fell for a seventh successive month in September. New-car registrations fell by 23 percent in the year to October. House prices fell by 2.2 percent in October leaving them 15 percent lower than a year earlier, according to Halifax, a big mortgage lender.

Until the summer, the main concern for most central banks had been whether they could cap inflation. Now the race is on to ease monetary policy in order prevent a prolonged economic slump. Shortly after the Bank of England’s big cut, Switzerland’s central bank reduced its policy rate by half a percentage point, to 2 percent. Earlier in the week, the Reserve Bank of Australia reduced its key rate, from 6 percent to 5.25 percent. Central banks in India and Vietnam also cut their benchmark interest rates in November.

The rate-setters at the Federal Reserve may look upon the scramble to lower rates with some satisfaction (although the IMF now thinks that America’s economy will shrink by 0.7 percent next year). Their judgment all along has been that the risks of a slump that would eventually push down on high inflation were greater than the risk that it would persist. But with interest rates already at 1 percent, the Fed has less scope to inject some life into the American economy. Some will argue that it is better to keep a little back in case things get really bad: a big rate cut can have an impact on confidence over and above the stimulatory effect of making borrowing cheaper. The Fed cannot now spring a surprise in the way that the Bank of England has managed. The ECB, however, could have and may now wish it had done so.

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