The Bank of England's monetary policy committee begins its latest monthly interest rate meeting today with a widespread expectation in the City that it will cut the Bank rate another half a percentage point, taking it to a new all-time low of just 1%. In the wake of a downgrade by the IMF of its UK growth forecast to a post-war low, a huge 1.5% contraction in gross domestic product in the fourth quarter, and thousands of job cuts in recent weeks, a half-point cut looks a done deal. But it is quite possible that the MPC will decide a bigger cut is required than most people are expecting. Why? Because the committee has been drawing up its quarterly inflation report, due out next week, which must have presented it with a big problem. With the economy contracting so fast, and inflation headed into negative territory, it is hard for the MPC to present growth and inflation forecasts for two years (its preferred time horizon) that show growth at anything like its trend rate of around 2.5% – or inflation anywhere near the 2% target – without rates a lot lower than they are now. The Bank's inflation target is symmetrical, meaning an undershoot is considered as bad as an overshoot. The CPI (consumer price index) measure of inflation fell back to 3.1% in December while the wider retail price index (RPI), which includes a measure of house prices and mortgage rates – both of which are falling fast – is down at just 0.9%. The RPI measure is likely to go negative very soon and the CPI not long afterwards. The interest rate cuts have been designed to drive it back up above zero again as soon as possible and towards the 2% target. So there seems little good reason for the MPC to hold back. It needs to get rates to zero or thereabouts as soon as possible and start taking the "unconventional measures" it has talked of, such as buying up corporate bonds. Of course, the argument goes that it is the quantity of credit available, rather than the price, that matters and thus some economists are arguing against further rate cuts and in favour of the unconventional measures. But there is always the chance that cutting rates further will feed through beneficially to the economy – think of all those tracker mortgages. The MPC has already slashed rates by 3.5 percentage points since October and in November cut them by 1.5 points in a single stroke. That move is now known as the "Blanchflower cut" since it was engineered byexternal MPC member David Blanchflower, who had long argued that rates needed to be cut sharply and swiftly. Although the committee only cut by half a point last month, to 1.5%, which took rates down to their lowest level in more than 300 years, that doesn't mean it can't speed up the pace of easing this time. There is a risk that such a move risks undermining sterling even further than it has been already, but markets also dislike it when they think a central bank is "behind the curve", as the Bank certainly has been until recently. Now it is the European Central Bank that is looking slow to act, with rates at 2.5% and no indication that it will cut them this week. There is some surprise among British officials that the IMF ranked Britain the worst performer of the major economies, given that Japan and the eurozone look to be in an even worse state. If the MPC were to slash rates down to 0.5% or even 0.25%, it would suddenly look to be ahead of the curve – and way, way ahead of the ECB. That could then help to support the pound, rather than undermine it.Bank must act fast to stop plunging inflation
Wednesday, 4 February 2009
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