Bank of England points to interest rate cuts

Wednesday, 12 November 2008 12:53 PM

The Bank of England has signalled more interest rate cuts could be in the pipeline.

The Bank's quarterly Inflation Report points to inflation dropping over 2009 - from the current high of 5.2 per cent to below the government target for the consumer prices index (CPI) of two per cent and staying low until 2011.

The report also highlighted the danger of deflation - or falling prices - as oil prices drop and so enables the monetary policy committee to drop interest rates further.

Mervyn King, governor of the Bank of England, said: "Since the August report the economic landscape has changed.

"The economy probably entered recession in the second half of 2008 and output is likely to contract further."

He predicted CPI inflation will fall to "materially below" the two per cent in 2009 and the Retail Prices Index (RPI) could become negative.

Mr King also warned "uncertainties were unusually large" given the lack of historical precedent.

The governor of the Bank of England also admitted the monetary policy committee (MPC) was prepared to cut interest rates further if it was needed to keep inflation to target.

Mr King told reporters: "For some time the MPC has been facing a balancing act between the short and medium term.

"Over the past three months, the prospects for inflation have fallen substantially on the downside. To return inflation to target it was necessary to cut interest rates."

Turning to the economy, the Inflation Report shows there is a chance a recession could last to the end of 2010.

However, the most likely outcome is for GDP growth to return in late 2009.

Mr King also defended the MPC against charges of being of out of touch and not cutting interest rates fast enough.

"We had not lost tough with reality. We projected a fall in output," he said.

"It is always possible to set policy with hindsight. No way MPC can have perfect foresight.

"Each and every month we look at balance of risks. There was a balance of risks until world changed in September."

Jonathan Loynes, chief European economist at Capital Economics said: "November's Inflation Report gives a very strong indication that the MPC expects to cut interest rates much further over the coming months."

He explained with CPI dropping one per cent below target in 2010 and GDP to contract across 2009, more interest cuts will come.

"Admittedly the forecasts do not take account of any fiscal loosening in the forthcoming pre-Budget report, but it seems very unlikely that this will get in the way of further deep rate cuts. One per cent (or below) here we come!" he concluded.

In the news conference Mr King also moved to put limited pressure on banks to pass on interest rates.

"It is important cuts are passed on. The spirit of recapitalisation was for banks to keep lending and we will monitor this," he said.

He also said the drop in interest rates and the bank recapitalisation plan would help to increase competition in the market for loans and credit cards, and so help to bring down rates.

"Considerable number of people will benefit [from the rate cut]. It is not easy for Bank of England to tell banks what pricing structure should be.

"Other interest rates depend on competitive in market, but bank recapitalisation and cutting interest rates will help."

Mr King also said he expected the government to cut taxes to boost the economy.

"It would be reasonable to see fiscal stimulus - provided it was temporary and it was clear there was a medium term plan to bring tax and spend back to balance."

Simon Hayes at Barclays Capital said: "A striking feature of the press conference was how keen Mr King appeared to be on harnessing the power of fiscal policy to 'support' monetary policy, saying that fiscal policy could be efficacious at present because the credit market dislocation meant monetary policy had lost some of its bite.

"In fact, one message from the Inflation Report seems to be that the MPC believes that monetary policy alone may be unable to prevent excessive disinflation and that significant support from fiscal policy may be needed."

He added he now expected interest rates to drop one per cent in December.

"We then expect further 50bp cuts in January and February, taking Bank Rate down to one per cent (we had previously seen a trough of 1.5 per cent)," he concluded.

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