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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.

More options available
Michael Saunders, chief European economist at Citi, notes the firepower still
available to the government. “The notion that monetary policy has ‘run out of
bullets’ with no scope to loosen further does not really apply.

It is only a question of which options governments and central banks are
prepared to use.”

Britain would not be the first to reach Zirp. Japan has held rates at around
0.1% for the best part of a decade, while the US has run an official rate of
between zero and 0.25% since December. The Federal Reserve has given a clear
indication of the way central banks are thinking. It is buying large quantities
of mortgage-backed securities to provide support to the housing markets and
looking at buying longer-term Treasury bonds.

So far there has been little guidance from Whitehall or Threadneedle Street
about their plans. The statement accompanying January’s half-point cut talked
about “further measures to increase the flow of lending to the non-financial
sector”.

One innovative idea in the UK comes from Danny Gabay and Shamik Dar, two
former BoE economists now at Fathom Consulting. They suggest the government
sells £50bn of bonds to the Bank, uses the proceeds to buy homes on the verge of
repossession and rents them back to the occupants to prevent families being
thrown out onto the street.

However, the strategy of cutting rates to zero and injecting billions of new
cash into the economy does have its risks. Printing more money, or taking steps
that amount to the same thing, risks fuelling a bout of inflation or even
hyperinflation. Zimbabwe’s annual inflation rate of 89.7 sextillion percent (10
to the power of 21) is the best example, if a little outside the current range
of possibilities.

But economists such as Roger Bootle, economic adviser to Deloitte, insist
that deflation is still a much greater fear than inflation. “The growing threat
of a persistent period of deflation – which in the worst case scenario could
lead to a self-sustaining spiral of weakening activity and falling prices – will
mean the MPC will not hang around in reducing interest rates to zero and
formally adopting a policy of quantitative easing.”

However, Investec’s Shaw warns that even this drastic strategy may not be the
panacea that some see it as. “The fact that the economy is still in distress
with longer-term gilt yields trading at historical lows and overall money supply
growth running over 16%, should be a warning that such measures are by no means
a guarantee of recovery.”

All eyes will now be on the statement and answers from Bank of England
Governor Mervyn King at the February Inflation Report press conference – or Firp
as it will probably now be known.

PAID BACK WITH INTEREST
The cut in Bank Rate to 1.5% may be grabbing all the headlines, but there is a
wide range of interest rates in the UK:

0.20% – First Reserve NatWest savings account AER (NatWest)

0.84% – Yield on UK 2% index-linked gilts 2035s (FT
12.01.09)

0.98% – Redemption yield on Treasury 6.25% 2010 gilts (FT
12.01.09)

1.50% – Bank of England Bank Rate

1.80% – Effective interest rate generated by Premium Bonds’
prize pool (National Savings)

2.3275% – 3-month sterling Libor (FT Alphaville 12.01.09)

2.42% – Redemption yield on Treasury 4.25% 2013 gilts (FT
12.01.09)

3.50% – First Direct tracker rate for a 25-year mortgage
(www.fsa.gov.uk)

3.78%
– Redemption yield on Treasury 4.25% 2055 gilts (FT 12.01.09)

4.20% – National Savings Guaranteed Growth Bonds Issue 45
guaranteed rate for first year (National Savings)

4.48% – Yield on FTSE-All Share index (FT 12.01.09)

6.12% – Yield on Tesco 20-year corporate bonds Rated A3,
Moody’s (fixedincomeinvestor.co.uk)

6.82% – Yield on FTSE General Retailers sector (FT 12.01.09)

6.90% – Standard Life Bank 20-year fixed rate mortgage rate
(www.fsa.gov.uk)

10.0% – Statutory interest rate on late payment (2009 H1)
(payontime.co.uk)

12.0% – Yield on banks’ preference shares issued to UK
government

19.9% – Debenhams Mastercard APR

21.43% – Yield on DSG International 2012 bonds (Rated Ba3,
Moody’s (fixedincomeinvestor.co.uk)

37.1% – APR on Virgin Atlantic Black Amex card from MBNA,
includes £115 annual fee (Virgin Money)

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