Interest rates doing the limbo, as banks slash to below inflation

The age of free money may be at hand.

As major central banks slash interest rates with unexpected speed, benchmark borrowing costs are now below core inflation for the first time since the early 1980s, and policymakers are signaling they will go deeper.

This week's cuts by the Bank of England and European Central Bank (ECB), which came with the Federal Reserve and Bank of Japan on the cusp of zero rates, are a bid to shock life back into their recessionary economies and strained money markets. It may be an uphill battle as consumers and businesses show greater interest in saving than spending, and banks hoard capital rather than lend it.

"It's the race to zero," said Stewart Robertson, an economist at Aviva Investors Ltd. in London, which manages about $230 billion. "There's no obstacle to more rate cuts."

The British central bank on Thursday axed its benchmark rate to 3 percent, the lowest level since 1955. The reduction of 1.5 percentage points was the biggest in 16 years. The ECB followed with its second half-point cut in a month, to 3.25 percent, and President Jean-Claude Trichet declined to rule out further moves south.

The action in Europe, which extended to reductions in the Czech Republic, Switzerland and Denmark, followed decisions last week by the Fed to drop its key rate to 1 percent, matching the lowest in a half-century, and the Bank of Japan to cut to 0.3 percent in its first paring in seven years. The central bank of South Korea on Friday cut its benchmark for a third time in a month.

Monetary policy is being eased because the 15-month credit crisis is inflicting harsher blows to growth and inflation than central bankers anticipated just two months ago. On Thursday, the International Monetary Fund cut its month-old forecast for next year's global expansion to 2.2 percent from 3 percent, and predicted the first contraction in advanced economies since it was created in 1945. It estimated prices would rise just 1.4 percent in rich nations, less than half of this year's pace.

The conundrum for central banks is their rate cuts may still not be packing a punch, even on top of record injections of cash and a willingness to accept lower-rated collateral for their loans.

One reason: Credit markets remain fragile, indicating financial institutions are still conserving cash after recording losses and writedowns of about $691 billion. The London interbank offered rate (LIBOR) for three-month loans fell to 2.29 percent Friday from 4.82 percent Oct. 10. The record drop still leaves the LIBOR 129 basis points above the Fed's benchmark, compared with an average of 22 basis points in the five years before the global credit crisis began in August 2007.

"The problems in money markets are still quite severe," said Dario Perkins, an economist at ABN Amro Holding NV in London. "Market rates are above where central banks have their rates, and that's alarming them."

Tighter standards ahead

Credit standards for loans to companies tightened "significantly" in the third quarter and will probably tighten again in the current quarter, the Frankfurt, Germany-based ECB said in its quarterly bank lending survey.

At the same time, companies and consumers are retrenching in the face of slowing growth and tighter credit. Cisco Systems Inc., the top maker of networking equipment, is forecasting the first revenue drop in five years because of the financial crisis.

ArcelorMittal, the world's biggest steelmaker, this week said diminished demand is forcing it to double production cuts.

Automakers and retailers are being battered by a collapse in consumer demand. Toyota Motor Corp. is forecasting the biggest drop in profit in at least 18 years. U.S. retailers Macy's Inc., Target Corp. and Gap Inc. all posted October sales declines.

The combination of cautious banks and reluctant spenders is forcing central banks to cut interest rates below inflation. J.P. Morgan Chase & Co. calculates borrowing costs adjusted for underlying inflation in developed markets fell below zero last month for the first time since the early 1980s and are still declining.

Central banks are betting that negative real interest rates will induce people to spend rather than save money that is declining in value, economists said. The strategy also aims to jolt investors and banks into seeking higher yields by making riskier long-term loans.

"It's clear you need to have interest rates that are lower than inflation going forward," said Jan Amrit Poser, chief economist at Bank Sarasin in Zurich, Switzerland. "Central banks are rushing to get interest rates down."

Still, it's "far too early" to talk about zero interest rates throughout the industrial world, given that inflation expectations remain positive, says Jim O'Neill, chief economist at Goldman Sachs Group Inc. in London.

"People should be wary of rushing to shift the debate from inflation to deflation," he said.