The Big Question: Will cutting interest rates save the economy from recession?

Why are we asking this now?

Because the Bank of England has cut interest rates again, for the third time since the credit crunch began. Yesterday's quarter percentage point cut brought rates down to 5 per cent. Their recent peak was 5.75 per cent, from July last year to December, when they were cut by a quarter percentage point, with a similar reduction in February.

How low can rates go?

As low as you like, though zero is usually thought of as a floor. Most analysts expect rates to fall to 4.25 or 4 per cent by the end of this year, and down again to 3.5 per cent by the middle of next year. The Bank of England has clearly indicated in its public policy statements that it expects interest rates to be on a broadly downward path over the next year or so. After that, who knows?

Why are they cutting rates when inflation is above target?

At 2.5 per cent, consumer price inflation is indeed significantly above the Bank of England's target of 2 per cent. Everyone from the Governor of the Bank, Mervyn King, down agrees that inflation will probably exceed 3 per cent in the autumn. At this point the Governor will have to write a letter to the Chancellor of the Exchequer explaining why inflation is more than 1 percentage point over the target. But right now there isn't very much the Bank can do about this inflationary shock, which we're seeing in rising food prices, energy and fuel bills. This inflation is "imported" because of soaring world costs and the depreciation in the value of sterling (partly due to reductions in rates). This inflation is now "baked in". Interest rate changes usually take 18 months or more to feed through to the economy, so it's too late to do anything about the current wave of price rises.

The Bank is hoping that people's expectations of inflation don't get too ingrained (which would lead to higher pay demands, for example) and that the general slowdown in the economy will be sufficient to pull inflation back down again. If inflation keeps rising and the economy stagnates, we'll see the return of the dreaded "stagflation" last seen in the 1970s.

So aren't falling rates good news?

They should be, but the credit crunch is so severe, and banks so unwilling to lend, that cuts in the Bank of England's official or "policy" rate don't seem to be getting through. The Bank rate influences very short-term, overnight rates in the money markets, but no longer, it appears, does that affect the crucial three-month and longer market for money, which is the important one as far as the banks are concerned. Most, if not all, of the loosening in rates since last winter has been offset by the credit crisis. The Bank say that the average cost of a 95-per cent two-year fixed rate mortgage, at 6.64 per cent, is actually the highest in eight years. Mortgage approvals are at 12-year lows.

Instead of first time buyers, for example, being able to take advantage of the Bank's policy and snapping up property bargains, the "mortgage famine" has left them still searching for a loan, and the market has been plunging as a result. The Halifax reported that house prices were down by 2.5 per cent last month and the IMF predict a 10 per cent fall in property this year. Next year could be grimmer still.

What about cutting rates some more – will that help?

It could do, but you eventually run out of ammo, that is, you approach zero. Keynes famously called the diminishing impact of rate cuts "pushing on a string". The Bank of Japan ran a zero or near-zero interest rate policy for much of the 1990s and the early part of this decade in a futile effort to revive its stagnant economy after the "baburu keiki" or bubble economy burst in 1990. Such was the collapse of confidence in Japan that such a lax policy had little impact. Consumer prices even began to fall in this era, so real interest rates remained positive even when they were zero, which made life for Japanese policy makers even more tricky. You also have to deal with a particular problem the economists call the "liquidity trap". When rates fall to such low levels, the next movement becomes more and more certain to be upwards.

When that happens, bond holders fear that the value of their securities will fall, so they sell in anticipation, and tend to hoard cash, so pushing the economy lower still. The authorities then lower rates again, only to make the effect worse until rates hit zero.

Has the Bank of England been slow to react to the threat of recession?

Arguably. Their "injections of liquidity" to help ease the credit crunch, they say, have been just as bold as those by the US Federal Reserve and the European Central Bank, but they have merely taken a different form, "for technical reasons" according to bank officials. Some still believe that they could have stalled the collapse of Northern Rock last autumn by making more money available to the financial system in good time, though the sums involved would have been colossal. It is true that the Bank of England has cut rates less aggressively than the US Federal Reserve, where rates have been cut six times since mid-September, to stand at a mere 2.25 per cent. The ECB, on the other hand, has left rates on hold since last June. Besides, the Bank of England is meant to control inflation, not the economy as a whole, although its formal remit is actually a little more flexible than that and it seems to be using what leeway it can to avoid a sharp downturn. However, even the gloomiest critics o f the UK economy still see it as avoiding "negative growth", whereas virtually everyone from the IMF to former Fed Chair Alan Greenspan sees the US as tipping into a mild recession anytime now. European growth is also lower than the UK's. Thus, the Bank's job of avoiding recession is less difficult than the Fed's or the ECB's, so it can get away with doing less. So far.

Will increasing Government spending help?

It can help. The White House has announced a $156bn (£79bn) stimulus package to support the Fed's attempts to revive a flagging economy and reverse the slump in real estate. However the British government has far less room for manoeuvre, not least because it is already in grave danger of breaching its own fiscal rules. There was a mild boost from the Budget, but nothing like on the scale that will be required to reverse a really bad downturn. The Government's main efforts seem focused on trying to get the credit market moving, through institutional reforms such as "kite marking" securities backed by mortgages. That will, supposedly, help the banks raise funds and start lending again.

Will yesterday's 0.25% cut do the trick?


* Interest rate policy by an independent Bank of England has been very successful over the past decade

* The UK's economy isn't so badly damaged that it won't respond to rate cuts

* Inflation is a danger, but will fall as the economy cools


* The nearer you get to zero real interest rates the less ammo you have to cut rates further

* If there's no confidence out there it doesn't matter how low the cost of borrowing is

* We'll simply end up with a stagnant economy but with higher inflation – the 1970s' nightmare of "stagflation" will return

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