BoE cuts interest rates again: is Zirp inevitable?

It sounds like a cross between a bodily function and a Star Trek alien, but Zirp could soon become an everyday feature of post-credit crunch economic life. The Bank of England kicked off the new year with a half-point cut in interest rates taking the official rate to 1.5%, the lowest level in its 315-year history. Just three more cuts of that magnitude and interest rates will be at zero – a zero interest rate policy, or Zirp.

So what will the world according to Zirp look like? The first impact is a symbolic one. It is the only level of interest rate to have its own name. To have a zero interest rate effectively means the Bank’s monetary policy committee (MPC) has run out of conventional bullets in its fight against the threat of deflation. The Bank cannot cut rates further without triggering a run on the banks as households withdraw their cash and hide it under the mattress to avoid effectively paying their bank to hold their money.

The second implication is that speculation over interest rate moves will shift from how far they will fall to how long they will stay at zero. As Malcolm Barr, chief UK economist at investment bank JP Morgan, says: “We would begin measuring ‘calls’ on the MPC in units of months rather than basis points.” If the Bank is no longer able to change the price of money then its only option is to change the quantity of money in the economy. For this reason economists call this unconventional monetary policy “quantitative easing”.

“There is no point in having cheap money if no one will lend it to you,” says Phil Shaw, chief UK economist at Investec bank. “Hence it is critical that the authorities get interbank activity up and running again quickly.”

Mind the lending gap
Businesses know this only too well. Official rates may be 1.5%, but three-month Libor, the interest rate at which banks lend to each other and which effectively sets the real lending rate, is 2.3%. The gap between two rates was wafer-thin until the credit crunch hit hard last summer when it started going up through 100 basis points with great regularity.

Meanwhile, figures from the Bank of England show that banks are simply not lending. Lenders tightened credit availability in the final quarter of 2008 by more than they had expected to do in the summer. More than half had raised the interest rate of commission for loans, its quarterly credit conditions survey showed.

There has been growing speculation the government and the Bank are planning a Zirp strategy. “There’s a debate to be had about what you do to support the economy as interest rates approach zero,” Chancellor Alistair Darling said after the Cabinet’s January meeting in Liverpool.

Short of printing money – which Darling has ruled out – the authorities have several other options open to them to boost the money supply and lower real interest rates:

• Buy securities such as government debt, corporate bonds and money market paper to raise the price and so depress the yield;
• Expand the Bank’s balance sheet and provide extra liquidity to the banking sector, pushing down interbank rates;
• Issue even more government bonds – gilts – than already planned, sell them to the Bank of England and use the proceeds to stimulate demand; and
• Set up a public sector bank and tell it – and the nationalised banks – to lend more aggressively to households and businesses at lower spreads.