Interest rate cut signals the end of free banking for all

THE BANK of England took a "leap in the dark" yesterday when it announced an unprecedented plan to inject £75 billion into the economy by effectively printing new money.

The governor, Mervyn King, revealed the Bank had been given permission by Alistair Darling, the Chancellor, to begin a high-risk initiative known as "quantitative easing" in an effort to bring the near-dead banking system back to life.

In a radical move described by critics as a "last resort", the Bank will offer to buy up UK government bonds – known as gilts – from banks and other financial institutions in the hope that they will use the new cash as a life-saving injection of finance to restore their lending to previous levels.

The lack of credit – which has made it virtually impossible for businesses and potential homeowners to get their hands on loans – is seen as the biggest obstacle hampering the fight-back against the recession.

The Bank was given permission by Mr Darling to spend up to £150 billion buying up gilts and bonds after it halved its base lending rate to 0.5 per cent, the sixth interest-rate reduction in six months.

It will look to invest an initial £75 billion over the next three months, with the first "reverse auction" of bonds taking place next Wednesday.

In an exchange of letters with Mr Darling, Mr King said the move was needed to address "highly uncertain times" and to deal with credit markets that are "not functioning normally".

He revealed that the Bank's monetary policy committee believed interest-rate reductions alone would not be enough to lift inflation back to 2 per cent in the medium term. Inflation is currently 3 per cent, but it is expected to drop sharply as a result of cheaper fuel and energy and the 2.5-point cut in VAT.

Mr Darling said: "It is absolutely necessary that we do everything we possibly can, and you will see in other parts of the world countries will be doing similar things over the next period.

"At the moment, the key thing for each and every one of us is to ensure we get the economy moving to help people and to help businesses grow.

"That will only happen if we allow the Bank of England the ability to improve the supply of money in the economy in addition to reducing interest rates. That is absolutely essential so that we can fix this and get through to recovery."

George Osborne, the shadow chancellor, said he supported the move, but admitted: "It's a leap in the dark."

He said it showed that previous attempts to revitalise the economy, such as the £12 billion VAT cut, had failed.

"The other risk is that it stokes inflation," he added. "The Bank of England will have to watch this like a hawk."

Vince Cable, the Liberal Democrat Treasury spokesman, also supported the move, which he described as "necessary and right".

He said: "There are risks that it will do little, and it will do too much. Given that interest rates can't be cut any further, this is the last resort for the monetary authority, the Bank of England, and to that extent I support it."

Mr Cable also rejected comparisons to Zimbabwe, where the president, Robert Mugabe, has taken to printing money to pay government debts – causing hyper-inflation and leaving millions unable to afford food.

"Britain is not in that situation. Mervyn King is not Robert Mugabe," Mr Cable said.

The move was announced yesterday by the Bank of England after its monetary policy committee agreed another cut in its base rate, taking it to another all-time low of 0.5 per cent.

It has never been at such a level since the Bank was established in 1694. The move was mirrored in Europe, where the European Central Bank cut its rate by 0.5 points to 1.5 per cent, the lowest in its ten-year history.

The euro-zone economy is forecast to shrink by more than 3 per cent this year.

The Bank of England said it had been forced to act because there remained a "substantial risk" of inflation undershooting the government's 2 per cent target.

Although the Bank did not state this explicitly, it was clearly concerned at the risk of the UK suffering deflation – when prices fall rather than rise, creating little incentive for firms to make goods.

This risks turning the UK's present recession into a longer-term depression, which could cause mass unemployment.

But by agreeing to a cash injection of £75 billion into the banking system, the government hopes the measure will increase spending and act as the lifeblood to the economy.

Quantitative easing: The bluffers' guide

THAT'S printing money, in layman's terms. But it's not all just about hitting "start" on the printing presses, as Bill Jamieson explains.

1. At the Bank of England (BoE), a man sitting at a PC taps a few keys to create an extra £75bn in reserves. (Yes, it really is that simple). This is not "real" cash but electronic credit.

Reward: First step in boosting money supply.

Risk: Sterling slumps, worries over UK credit rating.

2. The BoE offers to buy gilt-edged stock and bonds from banks, in return for the fresh new capital.

Reward: Banks will then pass on new cash to firms and families, stimulating economy. Hopefully.

3. Banks get the new money.

Risk: Banks may hold on to cash, reluctant to lend amid slump.

4. Credit feeds through to the real economy (goods and services). Hopefully.

5. More money needs to be printed.

6. The wider economy reacts.

Reward: Credit freed, recovery kick-started. Hopefully.

Risk: No-one knows how long this will take or even if it will work. It could spark inflation surge.

7. The BoE stops quantitative easing.

Reward: Stops surge in inflation. Hopefully. Risk: Economy hit by double blow - easing ends, inflation rises. BoE may have to raise rates to choke inflation.

Bill Jamieson: Bank opts for the nuclear option

EVEN with the latest cut in interest rates to a record low of 0.5 per cent, the Bank of England fears inflation will still undershoot the 2 per cent target – and even tumble into deflation – falling prices, further sapping confidence and investment.

So it has hit the nuclear button of Quantitative Easing – the technical term for raising the supply of money and credit in an attempt to boost banks' cash reserves and stimulate lending to companies and households.

QE does not mean printing money – at least not at first. The Bank credits its own reserves by a simple computer entry, just as if you were able to type in a credit to your own bank account.

The Bank's monetary policy committee has decided to implement QE straight away, initially aiming for asset purchases of £75 billion over the next three months.

Part of this will be directed at buying private sector credit – corporate bonds and asset-backed paper – but most of the purchases will be gilt-edged stock. These will be bought from clearing banks and financial institutions in return for which their coffers will be credited with deposits from the Bank. The government has given the central bank permission to embark on QE up to a maximum of £150 billion.

The £75 billion figure is more than most had expected. But will it work? QE is rather like pouring kerosene on the smoking embers of a log fire: you don't know how much you will need to ignite the fire and there is every risk it could flare up in a surge of inflation that could scorch the currency and take years to bring back under control.

So assessing the right amount is hugely uncertain. The initial £75 billion is equivalent to 5.3 per cent of GDP and similar in scope to that undertaken by Japan in the 1990s and the United States most recently.

There is another worry. It is not clear whether the expansion of the banks' reserves will actually encourage banks to lend. As Ben Bernanke, chairman of the US federal reserve, recently found, America's banks chose to leave the great bulk of their increased reserves idle, in most cases on deposit with the Fed.

In judging whether QE and the asset purchases are too little or too much, the MPC will be flying blind. This is new terrain and there is no handbook for the pilots. The MPC will monitor money and credit data as useful intermediate guides:

Finally, at some time the UK will face the problem of unwinding ultra-low interest rates, QE and other economic life-support measures, if and when the economy recovers. That, says the Citigroup economist Michael Saunders, "will pose difficulties and it will be hard to time the exit strategy without destabilising markets or the economy (or both]."

Such is the speed and scale of the downturn some worry if £75 billion over three months will be quick enough to stem a job-destroying slide in orders and output in the coming months. Others fear that the pound could take a massive hit.