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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.

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