Interest rates may drop to record lows in 2009

Homeowners and borrowers could see interest rates at record lows next year as policymakers battle to lift the UK out of recession, the Bank of England signalled today.

The Bank's latest gloomy forecasts predict the economy could contract year-on-year by 2 per cent in early 2009 unless rates fall further.

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The forecasts showed inflation undershooting the Bank's 2 per cent target by more than 1 per cent if rates remain at 3 per cent - supporting expectations that borrowing costs will plunge below the all-time low of 2 per cent.

Bank Governor Mervyn King gave a stark warning of the difficulties ahead for the UK economy and said "the world had changed" in the wake of the global banking crisis triggered by the collapse of Lehman Brothers.

"We are prepared when the world changes to make big changes to bank rate in response," Mr King added.

Interest rates are currently at a 53-year low after the Bank's biggest cut since 1981 last week. Rates have been lowered by 2 per cent since September.

Asked if interest rates could fall all the way to zero, Mr King said the Bank would set rates at "whatever level is necessary" to restore inflation back to its 2 per cent target.

Answering accusations that the Bank's Monetary Policy Committee (MPC) had been too slow to act to cut rates, Mr King defended the current framework, saying: "I think it's worked well and I think it will continue to work well."

He added: "It is always possible to set policy with the benefit of hindsight... there is no way in which the committee can have perfect foresight."

Based on market expectations of rates before last week's dramatic move, its forecasts show inflation falling from a current record of 5.2 per cent to less than half its 2 per cent target as food and energy prices fall back and demand eases in a looming slowdown. The MPC predicts a 10 per cent fall in energy prices in early 2009 after two rounds of hikes this year.

"We are moving into very difficult times and people should be concerned that we are moving into very difficult times, but that isn't to say we won't get through it," Mr King added.

The Bank's predictions are the first since the global financial crisis sent the UK teetering towards a recession which is set to be officially confirmed in January.

Although prospects for the Bank's official Consumer Prices Index inflation measure are less certain, the wider Retail Prices Index benchmark is "very likely" to turn negative next year as mortgage interest payments fall, the Governor added.

Mr King said the downward revision to the inflation outlook was the largest in the 11-year history of the MPC.

"Confidence has been shaken badly. All this will restrain demand looking into next year," he added.

The Government is set to announce plans to stimulate a flagging economy in Chancellor Alistair Darling's imminent Pre-Budget Statement with tax cuts and spending.

Mr King added that any fiscal stimulus package would be "perfectly reasonable" as long as it was a temporary measure and there were plans to restore public finances in the medium term.

The Governor warned publicly of recession for the first time in a speech in October. The report said today: "The economy probably entered recession in the second half of 2008 and output is likely to contract further.

"Consumer spending faltered in the second quarter under the weight of tighter credit and the squeeze on household budgets."

Hard-hit shoppers have been dealt a blow from higher prices, while a sliding property market has hit consumer confidence.

"Some households may have relied on cushions of housing equity as collateral against which they could borrow.

"But the combination of falling property prices and tighter credit conditions has both eroded the value of those equity cushions, and made it harder or more expensive to access them," the report added.