The Bank of England (BoE) today lowered its key interest rate by 50 basis points, taking the level to just 1.50%, the lowest since the central bank was founded in 1694. Since October, the BoE has cut rates by 3.50 percentage points as the domestic housing market worsened and consumer, business, and export activity weakened considerably. While this cut was slightly less than the market was anticipating, the Monetary Policy Committee (MPC) signaled last month that they wanted to begin slowing the pace of interest rate cuts to avoid fueling too much weakness in the currency or confidence. Moreover, the MPC has been discussing the uncertainty as to whether the current downturn will prove short-lived as fiscal stimulus, low commodity prices and falling inflation, and the weak currency would help stimulate demand for British goods. We continue to believe the BoE will ultimately cut interest rates below 0.50% and employ more exceptional measures in order to offset a longer than expected recession and ongoing disruption to the supply of credit. However, it is very likely that the pace of easing by the BoE will be slower than the ultimate economic realities warrant as they take a more cautious stance waiting for more evidence of where the economy will be later this year.
In making its decision, there was little change in the MPC's assessment that the economy would continue to contract in the first part of 2009, with weakness seen broadly across the spectrum. They also continue to see a significant risk of inflation undershooting their 2.0% target even discounting the impact of VAT cuts – and we would add a significant risk of slipping into outright deflation. However, building on their discussions in December (see ECB Press Conference Dissection), the MPC continued to move their assessment of risks back towards a more balanced view, albeit from the extreme downside. The sterling depreciation is expected to boost import prices, which could pass through into consumer prices, as well as help increase relative demand for British exports on the global stage. Although on this last point, this would be a larger share of a much smaller pie when it comes to global demand right now.
Since December, the MPC has been debating whether the U.K. downturn will prove to be a sharp but short-lived one time adjustment or a more protracted recession. This debate is well-warranted; however, we remain of the view that the U.K. economy is likely to contract by 2.1% in 2009 with weakness spread well into the second half of the year. This will warrant cutting interest rates close to zero and eventually employing some form of quantitative easing. But the latter, which will only likely begin later in the year and is a means of easing monetary policy once interest rates are close to zero, should be distinguished from measures to increase the supply of credit in the economy, which will likely be expanded in the near term and is little impacted by changes in interest rates.