Will interest rates fall to 0%?

Could UK interest rates fall to a record low of 0%? And what would the UK be like at such low interest rates?

This month the Bank of England slashed rates to three per cent – the lowest since 1954. But speculation is now growing that the Bank base rate could drop even further, even as early as December.

In 1939, interest rates stood at two per cent as Britain headed into war, and it looks likely as the UK battles with recession, the cost of borrowing could drop even further.

A drop below two per cent would see the cost of borrowing falling to its lowest since the Bank of England was founded in 1694.

Analysts at Capital Economics now even point to interest rates falling to zero per cent.

"The MPC's historic 150 basis point cut in interest rates will not stop the UK economy from enduring a long and painful recession.

"Neither does it mean that rates will no longer have to fall to an all-time low of one per cent. Indeed, the events of the past few weeks have made it more likely that rates might have to fall all the way to zero."

With inflation falling, Howard Archer, chief UK economist at Global Insight, forecasts rates of 1.5 per cent next year.

He predicts the Bank of England to cut interest rates by a further 50 basis points from 3.00 per cent to 2.50 per cent in December and to bring them down to 1.50 per cent by mid-2009 as it attempts to limit the effects of the recession.

"I wouldn't rule out further cuts," he said.

"Inflation could fall to 0.5 per cent next year and there is even the chance of a short spell of deflation.

"This would not be the end of the world if short enough."

0% Britain

So what would a zero per cent Britain look like?

"Cutting rates from two per cent to 1.5 per cent is a bit like pushing on a piece of string and how much it will affect people depends on the banks.

"There will be an effect for the people on the street. Savers will be badly affected having their saving rates cut back," explains Dr Archer.

"With inflation falling for to even 0.5 per cent, spending power will be boosted over the next year.

"But consumers are likely to keep their hands in their pockets and there is a need for consumer retrenchment."

However, he sees low interest rates not stopping the recession: "The UK is in a bad state – but it could limit the impact of recession."

0% borrowing?

Zero per cent interest rates at the Bank of England, however, will not mean free credit at the banks.

In a period where banks are trying to escape the losses of the credit boom, lenders will keep an eye on maintaining profits.

Much also depends on how much the high street banks are willing to pass on any rate cuts.

Borrowers on fixed rate mortgages will see no benefit from low rates – except when it comes to remortgaging – and borrowers on variable rate or tracker deals may only see part of full cuts.

Already many tracker mortgages have collars in place that stop the rates dropping if the Bank of England base rate drops below a certain level – although many borrowers will have no collar in place and their rates could really drop.

Banks also had to be cajoled by the chancellor after the November cut – even those part or fully owned by the state – into cutting their standard variable rates. Further cuts could see Alistair Darling battling against a brick wall if he wants more cuts on the high street.

Gordon Swan at mortgage broker mform.co.uk explains how low mortgage rates goes depends on the interbank Libor rate.

"If Libor drops, then rates may go down and the gaps on tracker mortgages could be depressed," he said.

But new deals are set to come with collars meaning further drops could be out of the question.

However, banks face a difficult balancing act as they are relying on consumers' savings to fund lending.

"If rates drop too far some people might be tempted to put their cash under the mattress or in their current account," Mr Swan said.

"There are some people out there with trackers now down at 2.75 per cent, but they can get an ISA – at the same bank – at over five per cent."

0% savings

The downside of a drop to very low interest rates is that those depending on savings for income are hit severely.

A two per cent reduction on a savings balance of £30,000 would see income drop by £40 per month (net of 20 per cent tax) or £480 over the course of a year.

While banks will continue to depend on savers for cash amid the gridlock on the money markets, rates will drop.

Andrew Hagger of Moneynet.co.uk is advising those looking to save to act quickly for deals disappear and lock into fixed rate deals.

"The shock decision to cut base rate by 1.5 per cent on 6 November has, as expected, had a devastating impact on savings rates with seven per cent plus deals now confined to the store cupboard where they are likely to sit and gather dust for some considerable time to come," he says.

"With the next rate cut expected as early as December 4th, savers with funds available to put away for between six months and two years still have time to lock into a decent fixed rate, but only if they’re quick off the mark."