LONDON (Reuters) - The Bank of England made a shock 1.5 percentage point cut in interest rates on Thursday to just 3 percent, their lowest level in more than half a century, as it seeks to prevent Britain from sliding into a deep recession.
That was the biggest official interest rate cut since the 1981 slump and completely wrong-footed analysts who had mostly been predicting a half-point reduction. Not one in 62 polled by Reuters had expected such a massive move.
The Bank said the economic outlook had got a lot worse and drastic action was now needed. Economists said more rate cuts would still follow and it was possible Britain could soon have rates the same level as in the United States -- 1 percent.
"The MPC needs to keep cutting interest rates aggressively. I think that they will need to fall to 1 percent," said Roger Bootle, an economic adviser for accountancy firm Deloitte.
"Rates have never before been this low, but extraordinary times require extraordinary action. And it is not impossible to imagine circumstances under which rates end up having to go lower, perhaps even to zero as they have done in Japan."
The sharp cut came as the International Monetary Fund forecast that the British economy would shrink by 1.3 percent next year, far more than the United States, Japan or the euro zone.
Two-year bond yields fell to a record low below 2.5 percent. The pound, already down about 20 percent this year, fell but then rose after the rate verdict, as investors bet the economy's growth prospects had improved.
The British economy shrank for the first time in 16 years in the third quarter and most economists expect further contraction through next year and only a small recovery in 2010, when Prime Minister Gordon Brown must call an election.
Economists polled by Reuters after the decision predict the Bank will cut rates by half a percentage point next month and again in the first three months of next year, taking rates to 2 percent by March.
The European Central Bank and Swiss National Bank also cut interest rates on Thursday as countries all around the globe try and cope with the fallout from the credit crisis that has felled some of the biggest financial institutions around the world.
Chancellor Alistair Darling said it was essential banks did everything they could to pass the Bank's rate cut on in full, but Lloyds TSB was the only major lender to do so immediately after the Bank's decision.
Union leader Brendan Barber said after a meeting with Brown late on Thursday that the prime minister was determined that the banks should pass on the interest rate cut.
"I think there is going to be real pressure (on the banks). They're going to have to respond. The public anger if the banks do not act responsibly would be absolutely massive," he said.
Share prices for the top 100 British companies took little cheer from the news, falling more than 5 percent on the day in line with their European peers.
Home builders were the only sector to see lasting share price gains after the rate cuts, as both they and their customers borrow heavily. Initial strong share rises were not sustained by retailers and pub chains, which are also highly geared and rely on discretionary spending by consumers.
Jacqueline Penny, 42, a healthcare support worker in Glenrothes, Scotland, said: "The rate cut will help us mortgage-wise, but the money saved will go on the extra costs of fuel and food."
Thursday's stunning Bank move follows a globally coordinated emergency rate cut of half a percentage point last month, meaning British rates have come down by nearly three percentage points since last December.
While some praised the latest Bank decision as courageous, others wondered why Governor Mervyn King, who often says he wants monetary policy to be boring, had taken so long.
One Bank policymaker David Blanchflower had been calling for rate cuts for most of this year but the majority of the Monetary Policy Committee had been fixated on inflation running significantly above the central bank's 2 percent target.
The economy has been slowing sharply. House prices started sliding a year ago as the supply of new mortgages has all but dried up in the wake of the credit crunch.
The average British home now costs 15 percent less than it did a year ago, according to the country's largest mortgage lender, raising the prospect of hundreds of thousands falling into negative equity -- their home worth less than their debt.
Consumer spending has also been taking a battering as Britons deal with not only the credit crunch but also huge rises in petrol prices and household bills over the last year.
Thursday's rate cut, if passed on in full, would reduce the monthly repayment on a 250,000 pound 25-year mortgage by 225 pounds, according to the Council of Mortgage Lenders.
Petrol prices have also fallen sharply, providing another boost to stretched household incomes.
The Bank will publish its updated forecasts for the economy next week.
"The UK has been living beyond its means for too long and a prolonged period of pain is inevitable," said James Knightley, economist at ING, which forecasts that the British economy will contract by 1.7 percent in 2009.
Additional reporting by Matt Falloon, David Milliken, Christina Fincher, Peter Griffiths, Adrian Croft and Kylie MacLellan in London and Avril Ormsby in Glenrothes, Scotland; Editing by Tom Hals