Recent interest rate cut – a sign of more to come?

As if the one-and-a-half point cut in UK interest rates on 6 November 2008 weren’t a big enough surprise for the markets, it now emerges that the Bank of England’s Monetary Policy Committee considered the need to cut rates by as much as 2%, or even more.

After reading the minutes of the meeting, released two weeks after the interest rate decision was announced, economists are now looking for a December rate cut of as much as 0.75% to 1.0%.

The minutes spell out that the markets had been expecting a cut of up to 100 basis points, but that the deteriorating economic outlook and the imminent collapse in inflation statistics made for a strong case to cut rates by at least 100 basis points. So quickly were all the indicators turning downwards that the committee was told a rate cut in excess of 2% might even be necessary in order to meet the Bank’s 2% inflation target in the medium term, and not to undershoot it.

The MPC was told if the path of interest rates followed then-current market expectations, inflation was likely to go as low as 1% by 2010, and could even go negative. Hence, a steeper-than-expected cut seemed appropriate. In the end, the nine members of the committee were unanimous in voting for a 150 basis point cut to 3.0% ­ the biggest cut in Bank Rate since 1981.

The imminent pre-Budget report, on 24 November 2008, was regarded as a good reason to hold back and not cut rates by as much as the inflation projections might have required, as those forecasts were based on public spending plans that might soon be rendered obsolete.

The committee also considered the shock impact that a large rate cut would have on the market and concluded that too large a cut could damage inflation expectations if there were an excessive depreciation of sterling. It also judged a very deep cut could be “misinterpreted” as a change in the MPC’s function, “which would damage the credibility of the inflation target”. Instead, it chose to leave some monetary loosening until after the market had had time to digest the November Inflation Report and to think about the 1.5% cut.

The minutes claim that the various stabilisation packages launched in the UK and around the world had succeeded in preventing very short-term money markets from completely seizing up and had “provided reassurance about the solvency and functioning of the banking system”. And yet, the spread of Libor over expected policy rates remained higher than it was in September, while spreads on sterling-denominated corporate bonds had widened by as much as 200 basis points, in part because reductions in growth forecasts pushed up the price of risk.

Falling economic activity
The MPC considered a range of output indicators from the UK and overseas, all of which signalled a sharp deterioration in economic activity:

• US GDP fell 0.1% in Q3 as other measures point to a further fall in Q4.
• The European Commission’s October business confidence survey scored 12-13 year lows, depending on the sector.
• Commodity prices were continuing to fall, with oil prices down by more than half since July despite OPEC output cuts.
• A squeeze on real incomes, tighter credit conditions and a probable desire to increase “precautionary savings” resulted in weaker consumer spending, especially for consumer services and durables.
• Car registrations fell 22% in the year to Q3, the largest drop since the series began in 1993.
• One consumer confidence survey hit a 20-year low and house prices were 15% lower than their October 2007 peak.
• Companies’ investment intentions fell sharply with the most recent statistics showing the biggest fall on record, partly because of the cost and lack of external finance.
• Export growth slowed markedly, more than offsetting the benefit of a weaker pound.
  

The MPC had access to the then-unpublished quarterly Inflation Report, which came out a week after the interest rate decision. Matthew Sharratt at Bank of America says the new assumption in the report ­ – that GDP will fall 2% year-on-year by early 2009 ­ – was as recently as August’s Inflation Report ascribed a zero percent probability.

Inflation, as measured by the consumer price index, hit 5.2% in September, but was regarded as likely to fall “well below” the 2% target, the report says. The MPC concluded that “a much lower level of Bank Rate was likely to be required to meet the inflation target in the medium term.”

Still, the MPC wanted to hold something in reserve when it took rates down by a point-and-a-half. Bank of America now believes that a 50 basis point cut is a “bare minimum” at the next meeting on 3-4 December and that a full-point cut to 2% is more likely. “With Governor King promising last week to take rates down to ‘whatever level is necessary’ to combat deflationary forces in the economy, we believe the Bank Rate will fall to a 1.5% trough early next year,” says Sharratt. “We see a small, but growing, chance that the trough in rates could be even lower at 1.0% by mid-2009.”

For more on the rate cuts, read our blog.