Money Story

03 July 2009 02:59 BST

Interest rates cut to 50-year low

The Bank of England has cut interest rates by 1.5 per cent in a drastic, unexpected and unprecedented move that leaves the rate of borrowing in Britain at a 50-year low.

The Bank's monetary policy committee (MPC) warned of a "severe contraction" to the country's economy as it cut interest rates to three per cent.

Today's unprecedented reduction in the cost of borrowing - the largest since 1981 and - comes after last month's 0.5 per cent cut and means the base rate has dropped two per cent in two months.

The MPC was able to cut rates as high inflation is now waning – and the rate-setters now see a danger to the economy from deflation as recession looms.

It is hoped the interest rate cut will boost the economy – and both the prime minister and the chancellor Alistair Darling have been pressuring the Bank of England to cut the cost of borrowing as the threat of a long-lasting recession looms.

A Bank statement read: "In the United Kingdom, output fell sharply in the third quarter. Business surveys and reports by the Bank's regional Agents point to continued severe contraction in the near term.

"Consumer spending has faltered in the face of a squeeze on household budgets and tighter credit. Residential investment has fallen sharply and the prospects for business investment have weakened. Economic conditions have also deteriorated in the UK's main export markets."

Edward Menashy, chief economist at Charles Stanley, said: "There is a growing feeling that the MPC has misjudged the severity of the recession and is therefore behind the curve.

"Taking the view that UK output will not reach the bottom until the second half of 2009, it is now possible to see base rates reaching a level of two per cent over the course of the next year."

Pressure is now mounting on the banks to follow the Bank of England and reduce the cost of borrowing to consumers.

Yesterday in parliament Gordon Brown said: "We want the banks and building societies to pass on the interest rate cuts to their mortgage holders."

However, lenders have been quick to emphasise the costs they charge borrowers are linked to the London interbank offered rate (Libor) which has remained high during the credit crunch as banks have been unwilling to lend to each other.

The Council of Mortgage Lenders (CML) said: "The real cost of funds to lenders is determined not by the Bank base rate, but by their own cost of borrowing."

Adrian Coles, director-general of the Building Society Association (BSA), welcomed the massive interest rate cut, but warned borrowers looking for new fixed-rate mortgage deals or homeowners with mortgages linked to money market rates will not necessarily find their mortgage rates decreasing.

"Building societies will do all they can to ensure that the cost of mortgage borrowing is as low as possible. However, the Bank Rate is just one of the issues that they have to consider," he said.

The hope is the measures put in place by the government – to guarantee interbank lending, buy into the banks and for the Bank of England to provide short-term liquidity – along with massive cut today would lower the cost of borrowing to small businesses and consumers.

Mr Brown claimed these actions were now starting to have effect.

"The Libor rate has gone down from 6.25 per cent to 5.25 per cent, we are starting to make progress," he said.

However, some commentators have hit out at lenders for building up profit margins over passing on interest rate cuts.

"Interest rate cuts by the Bank of England should gradually provide some support but the key issue is the extent to which these reductions are passed on into high street lending rates," said Simon Rubinsohn, chief economist the Royal Institution of Chartered Surveyors (Rics).

"Ominously some lenders are taking advantage of the current environment to rebuild margins, which will inevitably lessen the beneficial impact of the bank's actions."

Further cuts in the cost of borrowing are now expected in the coming months – with some analysts seeing the base rate dropping to unprecedented lows of one or two per cent.