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Europe, UK cut rates; UK expands money supply

(Agencies)
Updated: 2009-03-06 09:22

LONDON – Europe's two leading central banks cut interest rates to record lows Thursday to boost their recession-mired economies, but as rates near their floor all eyes turned to a radical alternative move by the Bank of England to effectively create new money.

Related readings:  Japan leaves interest rate on hold amid recession  Zero rate not suitable  UK inflation rate falls to 3 percent  Bank of Korea cuts interest rate to record low

The half a percentage point cuts by both the European Central Bank and the Bank of England took rates down to 1.5 percent and 0.5 percent as both banks battle to stimulate growth amid lower consumer spending, rising unemployment and falling exports from the world economic crisis.

The new levels were a 10-year low in the 16-country euro-zone and the lowest rate ever in the 315-year history of the British central bank, leaving both banks with little room for maneuver on traditional monetary policy although the ECB hinted it could make further cuts.

With little room to lower rates further, the Bank of England was the first to plump for so-called quantitative easing - or, more colloquially, "printing money" - announcing it planned to inject 75 billion pounds ($106 billion) into the banking system.

Instead of making new bank notes, the bank will buy assets, such as government securities and corporate bonds, over three months and pay for them by crediting banks' reserve accounts - effectively creating new money.

It is the first time quantitative easing has been used in modern Britain, underscoring the extent of the downturn engulfing the country.

ECB President Jean-Claude Trichet also gave one of his broadest hints yet that the European Central Bank may back a similar program to boost the money supply in the euroz one, which accounts for more than 15 percent of the world's gross domestic product.

The hope in Britain is that banks will use the newly created funds to stimulate wider lending, rather than hoarding the reserves, which would blunt the effect of the easing.

The measure also carries the risk of fueling damaging inflation in the longer term, but Bank of England Governor Mervyn King said that it was warranted "in these highly uncertain times."

King said the success of the British plan depended in part on what happens with the global economy from here.

"We're all in it together," King said in a rare interview broadcast on British TV. "But if countries work together, these measures will, I believe, eventually work."

Trichet told reporters at the ECB's headquarters in Frankfurt that the European bank was "discussing and studying possible new nonstandard measures."

Quantitative easing was implemented in Japan at the beginning of the decade, where its success was questionable after much of the money was hoarded by banks. Economists also argued that the policy had been implemented too late in the Asian country's economic downturn.

The opposition Conservative Party's economic spokesman George Osborne said the British measure was a "leap in the dark."

"I don't think anyone should be pleased we have reached this point," Osborne said. "It is an admission of failure."

The British government has authorized a maximum of 150 billion pounds for the program and the Bank of England said that it will adjust "the scale of purchases as appropriate" after monitoring its effectiveness at its future meetings.

"If investors are to become in any way optimistic that this policy will work, it will only come at the cost of growing concern over the long-term inflationary implications of the policy," said Bank of New York Mellon currency strategist Neil Mellor, reflecting concerns from economists about the success of the measure.

"As such, in conjunction with ongoing frailty in the banking sector and an ongoing economic downturn of unknown proportions, an era of quantitative easing is one more thing for investors to worry about," he added.

Both rate cuts announced Thursday were widely anticipated as the ECB and Bank of England face the specter of possible deflation and the ECB's Trichet indicated that there was room for at least one more half percentage point rate cut to 1 percent, though he failed to provide a clear sign as to whether it could be enacted next month.

"As far as the current rate, we did not decide ex-ante that this was the lowest rate we could attain," he said.

Inflation in the euro bloc crept up to 1.2 percent in February from a near 10-year low of 1.1 percent the previous month, but that was still well below the ECB's target rate of "close to but below" 2 percent.

Trichet said that inflation was likely to be well below 2 percent this year and next and could turn negative in the middle of the year on a continuing sharp fall in commodity prices.

In Britain, the central bank expects inflation to fall below its 2 percent target by the second half of the year after dropping to 3 percent in January.

The euro zone, which has 330 million people, and Britain both fell into recession last year.

The ECB has forecast a 2.2-3.2 percent fall and in gross domestic product over 2009. The British government has predicted a 2.8 percent drop.