Jeremy Warner: Bank is fast running out of road on rates

Outlook So in the end, it was "just" the half point, rather than the full point some had been calling for. Just to rewind, that's "just" half a point. Up until four months ago, a half-point cut in interest rates would have been regarded as a near panic measure.

What's more, a reduction in bank rate to as little as 1.5 per cent, the lowest since the Bank of England was founded in the immediate aftermath of the Glorious Revolution of 1688, would have been barely imaginable.

Yet today, the Bank of England finds itself accused of being overly cautious and measured in its approach. It seems more than likely that rates will fall close to zero over the next few months anyway, so why not just get on with it?

Yesterday's accompanying statement provides a few clues. One is the self-evident point that although inflation is falling fast, it's still well above target. Nor is it yet at all clear that inflation as measured by the Consumer Prices Index will, in fact, turn negative over the next year, let alone stay there for years to come, as some are predicting, in the grips of a deflationary slump.

The Monetary Policy Committee also expresses some nervousness about the devaluation of the pound, which on the whole it views as a useful reflationary tool but is none the less worried about its impact on import costs. Further depreciation may be more negative for the UK economy than positive if the effect is to put upward pressure on interest rates.

Perhaps, too, there is an ulterior motive. Once interest rates hit zero, the Monetary Policy Committee is largely out of a job, so in holding something back, the Bank may be simply hoping to prolong its raison d'etre. Yet the more important reason for the Bank of England's cautiousness is the one not covered by the statement, which is that interest rates are already so low that it may no longer make much difference to the real world if they go lower still. Many mortgage rates are already as depressed as they are ever likely to get, whatever further action the Bank of England takes on bank rate, while savings rates were weeks ago cut to close to zero.

The problem for some time has been not so much the cost of credit, as its lack of availability, and a growing reluctance to borrow. These latter issues are not going to be addressed by further interest rate cuts. The MPC's half-point cut yesterday therefore becomes as much a psychological manoeuvre as one of meaningful traction. Half a point is enough to make people think the MPC still has the power to act, but not so much that it panics people into believing there's a slump on the way and causes sterling to go into a renewed nosedive.

You can argue it both ways, but more dramatic policy action would have done more harm than good if it convinced everyone that a deflationary spiral was indeed the most likely outcome. As it is, this still strikes me as a quite unlikely end game. Yet obviously the authorities need to do something to get people borrowing, investing and spending again. If cutting interest rates is no longer the answer, what more can be done?

One obvious policy initiative which is probably no more than a few weeks away from being announced now is to extend the state guarantee which is already available to interbank lending to direct lending on mortgages, consumer finance and business credit.

There are also a whole series of measures that can be applied which fall into the category of "quantitative easing", the effect of which would be to expand the amount of credit and cash in the economy.

One would be for the Bank of England as agent for the Treasury to buy up longer-dated government bonds, as the Federal Reserve has already said it might do in the United States. Alternatively, other forms of debt, such as mortgage-backed securities or corporate bonds, could be bought instead. The buyer doesn't have to be the Bank of England. A sovereign wealth fund might be created to hold these assets on behalf of the nation, or perhaps even to help fund Britain's burgeoning public sector pension liabilities.

Unfortunately, there is no guarantee that the money thereby injected into the economy would actually be spent. For portfolio managers and banks which have already suffered catastrophic losses elsewhere, the temptation would be merely to hoard or save the cash. For years, politicians and general do-gooders have urged the nation to save more, yet more saving is just what the economy doesn't need right now. To thecontrary, what's needed to prevent a vicious circle of rising unemployment is for everyone to start spending and investing again.

What Keynes called "the paradox of thrift" is already in danger of sinking us all. Putting money away for a rainy day is self evidently a right and proper thing to do, but if too many people do it all at the same time, it collapses demand and thereby economic activity. To think that Britons have overnight turned from being a nation of debt-fuelled spenders to one of self-righteous savers may be going a bit far, but certainly paying down borrowings has become the overwhelming priority for many. In any case, the effect is the same – reduced consumption.

As interest rates approach zero, the Bank of England loses much of its purpose. Once it cannot cut interest rates any further, there will be nothing more for the Monetary Policy Committee to do at its monthly meetings other than ruminate on the general state of the world. That's why it is lobbying so hard for the primary role in deciding how and when to apply quantitative easing. If having an independent monetary policy means anything, then surely it should be in charge of quantitative easing too?

Well, possibly, but the reality is that with interest rates at zero, the distinction between monetary and fiscal policy becomes largely meaningless and so too does having an independent central bank. Whether the money earmarked for fiscal stimulus is printed or borrowed, it's the Government which is in the driving seat from here on in.

Back in October, Mervyn King, Governor of the Bank of England, promised in a speech that the long march back to boredom and stability had begun that very night in Leeds. I fear he may have been a little premature. Events are about to get very interesting indeed.