Will Rate Cuts Revive Flagging Housing Market?

The Great economist John M Keynes said interest rate cuts were about as effective as pushing a piece of string.

His point was that in a great depression with very low confidence and expectations of falling asset prices, we tend to move into a liquidity trap. A liquidity trap means lower interest rates fail to increase demand in the economy.

Yesterday, the Bank cut rates by another 1% leaving rates at 2% – the joint lowest rate ever. The government and the Bank will be fervently hoping that Keynes’ assertion will prove an exaggeration.

The cut in rates is so steep, it could easily be the curve for share price in Woolworths, the price of precious metals or average UK house Prices. It shows how the recession has hit much harder than the Bank expected and also shows that cutting rates is being less effective than usual.

In a recession rate cuts prove less effective because:

• Lenders don’t want to lend (or can’t lend) – Mortgages will still be rationed because lenders require a large deposit. A large deposit actually makes sense with house prices falling as quick as they are.
• Low Confidence
• See other reasons – When Greenspan was nearly God – and the failure of monetary policy.

However, cuts in interest rate will help because:

• Personal debt levels are very high. Borrowers will see rising disposable incomes because debt repayments will fall. True savers lose out, but, the UK is a nation of borrowers not savers these days.
• Banks may not pass the whole rate cut on (though nationalised banks will be under pressure to). But, even so, anyone with a variable, or tracker mortgage will see lower mortgage payments.

Will It Stop House Prices falling?

No, The dramatic fall in house prices is not because interest rates are high. The cut in rates will help a little, it will help reduce the likelyhood of a sharp rise in repossessions. But, the downward momentum of house prices will not be stopped by cheaper mortgages. The problem is the shortage of mortgages and the expectation of falling prices.

Will We See Interest rates fall to 0%

It depends whether recession continues to worsen or gets better. At any sign of inflation dropping below 1%, the Bank will cut interest rates to 0%. If they have any sense (and I think they do) they will do anything to avoid deflation which devastated Japan in the 90s and 00s and the UK in the Great Depression.

The recent signs suggest that the economy continues to contract at a high rate.

How Long will interest rates stay so Low?

For those lucky enough to take out a mortgage, I would expect rates to stay low for the medium term upto 1-2 years. When the economy recovers in 2010, interest rates could soon return to 5-6% levels as inflation returns. This is not guaranteed, but one shouldn’t expect permanently low rates.