How low can interest rates go?
		Many savers and borrowers need to review their finances as returns decline Financial Times, Feb 24, 2001 Whether you are a saver or a borrower, interest rates are coming down. The Bank of England has shaved base rates from 6 per cent to 5.75 per cent. Halifax and Nationwide, two of the biggest mortgage lenders, followed this with bigger cuts in standard variable rates. The question is: how low can rates go? In the short term, the answer would seem to be: not muchfurther. The Bank of England's base (or repo) rate is primarily an economy-adjusting tool. If the economy is sluggish, lowering the base rate makes borrowing cheaper and encourages people to spend more. Raising rates can slow spending and help to cool an overheating economy. Most economists think the UK's economy is running at just about the right temperature. The Bank's recent cut was more of a pre-emptive strike in case a US-style slowdown was coming our way. Further cuts are likely - the Bank's monetary policy committee was unanimous in its support for the latest reduction - but they are likely to be small. "I am looking for a 50 basis point (0.5 percentage-point) cut by the end of August," says John Butler, UK economist at HSBC. "Some people are saying 100 basis points, but you can't be aggressive with interest rates. Big cuts today just lead to higher interest rates tomorrow." If Butler is right, the UK would go into 2002 with base rates at 5.25 per cent - not high, but certainly not as low as rates could go in two to three years. Interest rates in the euro zone (Germany, France, Italy and the rest) stand at 4.75 per cent, which is "a bit too high" according to Butler. If the government is serious about preparing the economy to adopt the euro, UK rates would have to fall by 1 percentage point from current levels. Looking at the longer term, however, is there a level below which the base rate (and consequently mortgage and savings rates) simply cannot go? Says Butler: "The base rate could go to zero, but there would have to be something very wrong with the economy if you had to stimulate it that much. Besides, at that level there is no more room for manoeuvre." Economists disagree about where base rates lose their usefulness, but, argues Butler, "3 per cent is about the lowest possible rate, 4 per cent would seem to be a reasonable UK bottom." Indeed, there is a growing consensus among economists that UK base rates could now be set in a range of 4 to 6 per cent - at least as long as Britain remains outside the euro zone. The big question for savers and borrowers is whether a further 1.75 percentage point cut - bringing base rates down to 4 per cent - would be passed on to them by banks and building societies. This is certainly not a foregone conclusion. Most high street lenders rely for funding on money deposited by savers. The danger is that savers will simply switch into other assets - equities, bonds, or residential property - if deposit rates fall too far. "One of the factors that stops mortgage rates falling in an unlimited way is the amount banks have to pay savers to get them to save with them," says Ray Boulger, senior technical manager at Charcol, the mortgage broker. "New-style lenders such as Cahoot, who borrow mainly from the money markets, could offer cheaper mortgage products, but high-street lenders, who have to look after their savers, would not be able to keep dropping their rates." Considered in isolation, there is no reason why mainstream mortgage rates could not fall below 5 per cent, less than 1 per centage point above the presumed "floor" for UK base rates. Rates lower than this are available on the high street. Boulger says the cheapest headline mortgage rate available with no strings stands at just 4.77 per cent. However, such special offers are loss-leaders, offered by lenders trying to grab market share or make money by selling insurances or investments. This practice is widely seen as unsustainable. Setting aside loss leaders, which distort the market, banking analysts argue that it is hard for any lender to make money out of home loans priced at less than half a percentage point above the base rate. Banking overheads have been reduced significantly over the past few years - thanks to mergers, staff cuts, branch closures and the neat trick of getting customers to be their own cashiers by logging on to the internet - but a 0.5 per cent margin over base rates is reckoned to be the bare minimum for even the most efficient lender. (Nationwide this week set its variable rate at 6.49 per cent, 0.74 per cent over base rates.) Put these together and you get a likely bottom level for non-discounted mortgages of 4.5 per cent, with 4.75 per cent seeming a more reasonable estimate. But with rates this low, surely savers would desert the banks. Surprisingly, there are two reasons why this may not be the case. First, low interest rates usually occur in a period of low inflation, so the real (inflation-adjusted) rates of interest savers enjoy are higher than they first appear. Earn 6 per cent on your deposits when inflation is 2 per cent and you are better off to the tune of 4 percentage points at the end of the year. Earn 10 per cent at a time when inflation is 14 per cent and you are 4 percentage points adrift in real terms. While there is evidence that savers find it difficult to think in "real" terms, an exodus from bank deposits seems unlikely while inflation remains under control. The second lesson comes from Japan, where the economy has stalled and the base rate is virtually zero. Adam Cole, an economist at HSBC, points out: "In Japan some 10-year-old savings products have been maturing, and the expectation was that the investors would put their money straight into equities. Instead, a significant proportion of the cash went straight back on deposit at something like 0.2 per cent interest. It seems that people will take very low returns in exchange for lack of risk. At least you can't sustain capital losses with a bank." There is no reason to think that the average UK depositor is any less risk-averse. Adrian Coles, director-general of the Building Societies Association, says: "From the point of view of depositors, you have to ask what the alternatives are. My view is that the system will function with base rates at 4 per cent, mortgage rates at 5 per cent and savings rates at 3."