Deep rate cuts in Europe

Interest rates were slashed across Europe on Thursday as the continent’s central bankers decided the outlook for their economies had taken a decisive turn for the worse.

In the UK, the Bank of England cut rates by 1.5 percentage points to 3 per cent, bringing the official rate to its lowest level in 54 years. The cut was three times bigger than any seen since the central bank’s monetary policy committee was established in 1997.

The European Central Bank cut official borrowing costs by half a percentage point to 3.25 per cent and Jean-Claude Trichet, ECB president, said he would not “exclude” a further cut in December.

In other moves, the Czech central bank unveiled a much larger than expected three-quarter percentage point cut in official borrowing costs, while the Swiss National Bank also said it was lowering interest rates.

The rate cuts came as the International Monetary Fund published an emergency update of its economic forecasts, predicting the rich world’s economies would shrink by 0.3 per cent next year, the first contraction since the second world war. Last month it projected 0.5 per cent growth for 2009.

The IMF recommended the US, Europe and China should raise public spending and cut taxes.

As the IMF was predicting a dire year ahead for rich economies, fresh signs emerged of the pain in the US jobs market. The number of Americans filing new claims for unemployment benefits remained more than 50 per cent higher than before the financial crisis hit in 2007 as the insured unemployment rate climbed to its highest level since February 1983.

Equity markets slumped amid traders’ expectations that the weakness in the global economy would hit corporate profits.

In London, the FTSE 100 index closed 5.7 per cent lower at 4,272.

But this was not simply a reaction to the Bank of England’s dramatic rate cut. German and French equity values both fell more than 6 per cent. The S&P 500 index ended the day 5.2 per cent lower at 903.43.

The Bank of England said its dramatic move was a response to tightening credit conditions; the evidence of a “severe contraction” in the economy over coming months; and such a dramatic extinction of inflationary pressure that “at prevailing market interest rates, [there is] a substantial risk of undershooting the inflation target”.

Traders and economists took that final phrase to signify further rate cuts to come as the prevailing market interest rates already envisaged rates falling to 2.5 per cent. Market expectations are now for rates to fall below 2 per cent over the next year.

Speaking after the ECB’s move, Mr Trichet was clear that banks had to respond to lower official rates by bringing down market interest rates. “We expect the banking sector to make its contribution to restore confidence,” he said. He highlighted the large sums still being deposited by banks at the ECB overnight – rather than being lent to other banks – as a sign that markets were not functioning normally.

The ECB’s strategy contrasted with that of the Bank of England, which does not expect a change in the market to come soon and as a result has cut rates even further.

The size of the cut in UK interest rates appeared to have taken the ECB by surprise, but Mr Trichet played down the differences in approach. “Central banks are a brotherhood of mutual admiration, which is very strong,” he said.

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