UK interest rates may be headed for record low

LONDON (Reuters) - British interest rates have already been cut to their lowest level since the 1950s but investors are betting they won't stop there.

With the economy reeling from the worst financial crisis in living memory and a recession a looming inevitability, inflation worries have been replaced by the hitherto unthinkable -- the threat of deflation.

In a statement accompanying Thursday's 1.5 percentage point cut to 3 percent, the Bank of England said the deteriorating economic outlook meant there was now a "substantial risk" of inflation undershooting its target.

Futures prices show investors are betting interest rates could fall to 1.75 percent next spring. That would be the lowest since Bank of England records began in 1694.

Some economists reckon rates may need to fall even further. As Japan showed after its asset bubble burst in 1990, if there is no demand for funding, even zero interest rates cannot kick-start an economy.

"The pall of gloom enveloping firms and households means that demand may be rather insensitive to interest rates at present," said Simon Hayes, an economist at Barclays Capital.

"If credit supply does not show any material recovery over the next few months the policy rate may need to be cut to 1 percent or even lower."

NEGATIVE REAL RATES

With inflation running at a 16-year high of 5.2 percent, British interest rates are now significantly negative in real terms. But this situation is unlikely to last. Inflation is set to crumble in the coming months as the economy contracts and commodity prices fall.

George Buckley at Deutsche Bank reckons retail price inflation -- a broader measure of price moves which includes housing costs -- could even turn negative next year and predicts British interest rates will fall to 1.5 percent.

"Extraordinary circumstances call for extraordinary interest rate levels," he said. "There is only one lower boundary for interest rates and that's zero."

The Bank of England will set out its latest thinking on the economy and interest rates in its quarterly inflation report next week. The tone of Thursday's statement suggests both inflation and growth forecasts will be subject to hefty downward revisions.

The quicker central banks act, the less they typically need to do, so there is an argument that Thursday's dramatic rate cut -- Britain's biggest since 1981 -- means rates may not need to be cut so low.

Japan's tardiness in cutting interest rates when its bubble burst and the government's reluctance to get banks to own up to their bad debts contributed to what economists have termed its "lost decade."

In contrast, Britain has set the international agenda in using taxpayers' money to shore up major banks.

"Parallels with Japan are not all that accurate," said Philip Shaw, chief economist at Investec, who is sticking with his forecast that rates will trough at 2 percent early next year.

"Japan refused to cut rates aggressively in the early days and their authorities did not recapitalize the banking system in the way Britain has done."

(Editing by Adrian Croft)