The Bank of England slashed interest rates to their lowest level since 1951 yestrerday but said further steps would be required to prevent a credit squeeze tipping the country's economy into a deep recession.
Both the government and the central bank have taken dramatic action to pump cash into the economy in recent months but businesses and consumers are still finding it hard to borrow.
The cut of a full percentage point to two per cent had been widely expected following a raft of dismal economic indicators in recent days. Some in the market had expected an even bigger cut and gilts eased and the pound recovered after the decision.
In a statement accompanying the decision, Bank policymakers noted that credit conditions remained extremely difficult and "it was unlikely that a normal volume of lending would be restored without further measures".
The government has already pumped £37 billion of taxpayers' money into major banks to prevent them from collapse and offered unprecedented guarantees to encourage them to lend again. However, anecdotal evidence suggests banks are still tightening credit.
"Lowering borrowing costs will of course help, but what is currently even more important than the price of money is the quantity of money," said Philip Shaw, chief economist at Investec. "There is no point having very cheap money if no one will lend it to you."
Analysts said the Bank's statement left the door open for further rate cuts, which would take monetary policy into uncharted territory. British interest rates have never gone below two per cent since the central bank was created in 1694.
The European Central Bank cut rates by 75 basis points yesterday, its biggest ever move.
With the monetary transmission mechanism shattered by the credit crunch, the onus will also fall to governments to try to boost demand with more targeted policy measures.
The Bank noted a £20 billion package of tax cuts and spending increases, announced by the government last week, had yet to work its way through and the temporary reduction in value added tax would lower inflation next year.
"The economy is stalling, inflation is expected to undershoot the Bank's own target and headline retail price inflation is likely to turn negative for at least a few months in 2009," said Ian McCafferty, chief economic advisor to the CBI.
Most of the UK's biggest banks pledged to pass on the Bank's rate cut in full to homeowners with tracker mortgages, but said they were still considering whether to do the same for borrowers paying standard variable rates. With its reliance on financial services and high levels of personal debt, Britain's economy has been particularly hard hit by the global credit squeeze. House prices are tumbling, unemployment is soaring and consumer confidence has taken a dive. Stores are slashing prices to lure in shoppers.