BoE likely to deliver biggest rate cut in 15 years

The Bank of England could deliver its biggest interest rate cut in 15 years this week as it tries to prevent a prolonged and painful recessio
n.

Mounting evidence that the economy is shrinking sharply has led markets to price in a rate cut of three-quarter of a percentage point, which would be the biggest cut since 1993 and in the 11 years since the Monetary Policy Committee was set up.

Ten of 62 analysts polled by Reuters on Tuesday predicted borrowing costs, currently at 4.5 percent, could fall by a full percentage point. That would also be the biggest rate cut since 1993 as the MPC rarely moves rates by more than a quarter point.

The financial crisis has completely changed old habits with policymakers saying they have not seen anything this bad before. Last month, the BoE, along with other major central banks, delivered an emergency half point rate cut.

The European Central Bank is also expected to cut interest rates by half a percentage point on Thursday, according to analysts. Some investors are betting on an ever bigger cut.

"The MPC needs to make aggressive cuts in the Bank Rate in the months ahead: our assumption is a cumulative 200 basis points by February," said Geoffrey Dicks, chief UK economist at RBS. "If that is correct, the November decision is mainly tactical."

Bernanke moment

In a blunt speech last month, BoE Governor Mervyn King said the British economy was likely entering recession, comments widely interpreted as opening the doors to much lower rates, as Federal Reserve chairman Ben Bernanke did in January. Economists say another half point rate cut is a done deal. The question is whether the BoE will do more.

MPC member David Blanchflower, once the sole voice calling for lower rates, looks certain to vote for a full percentage point reduction, but his colleagues may prefer to be more cautious. They could cut by half a percentage point now and deliver another half point before Christmas.

But given the clamour for a bigger move, a 50 basis point cut could actually end up being a disappointment. Opting for a 75 basis point rate cut now would no longer smack of panic as markets have priced it in. But the BoE may also prefer to save its thunder for now as there are only so many confidence-boosting rate cuts it can deliver when rates are already at 4.5 percent.

In the early 1990s, rates fell in 1 percentage point moves but had been in double-digits previously. Cutting rates very rapidly now might perversely also lift sterling which has fallen sharply in recent weeks. Policymakers expect the weakness in the pound's exchange rate to help boost the economy, even though weak global demand may mean this effect is less pronounced than in the past.

Moreover, rate cuts will help less than in the past since lenders, who are suffering from a global credit crunch, are not necessarily passing them on to borrowers. That means rates may need to fall even lower than the half-century low of 3.5 percent seen in mid-2003.

"We expect rates to fall to just 1 percent or so, but the credit crunch has diminished the effectiveness of monetary policy," said Vicky Redwood of Capital Economics.

Source: EconomicTimes