Bank of England Preview

December 2, 2008

The Bank of England will cut its Bank Rate by at least a full percentage point on Thursday, and there is a possibility officials will replicate November’s 150-basis point reduction. A dramatic downshift in the BOE’s projected CPI path indicated that such would be likely below 1% in two years’ time if the rate remains at 3.0%. Officials concluded that the Bank Rate, which had been cut since December 2007 by 125 basis points to 4.5%, might need a drop of over 200 basis points in November but opted for the smaller 150-bp move because a more drastic action had not been properly communicated ahead of the meeting. It has now.

Nothing has happened in the past month to strongly justify a lesser easing of monetary policy. The U.K. is expected to suffer the sharpest drop in real GDP among G-7 economies; a calendar year decline of 2% in 2009 is plausible. British real GDP declined 2.0% at a seasonally adjusted annualized rate last quarter. The manufacturing PMI fell from 40.7 in October to 34.4, the lowest score in at least 16 years. John Lewis Department store sales are down 14% on year, and the distributive trades survey, another forward-looking gauge of retail activity, plunged to a series low of -46 in November from -27 in October. New car sales fell 23% below year-earlier levels, and housing is imploding. The construction PMI fell from 35.1 in October to a series low of 31.8 last month. Industrial production dropped 4.3% saar last quarter.

A severe shortfall of aggregate demand caused unemployment to climb 108K between July and October. Wage pressures are melting away. Earnings rose only 3.0% in the year to September. Expected inflation is at a 2-1/2 year low. The reversal of oil and other commodity prices is reinforcing the U-turn in inflation. In October, producer input prices sank 5.6% from the month before, and producer output prices dropped by 1.0%. Bank of England Governor King recently predicted that retail price inflation may drop below a 12-month rate of zero for a while next year.

Minutes from the November 5-6 Monetary Policy Committee meeting revealed a predisposition to peruse the subsequent Pre-Budget Statement before deciding the timing on incremental further monetary easing. The planned fiscal stimulus will lend the economy limited support but will also blow a big hole through public finances that will take many years to repair. However, for an economy as weak as Britain’s, future public finances are best served by restoring positive economic growth. Both monetary and fiscal policy have roles to play in this process. With a nominal bank rate of 3.0% and an expected inflation-adjusted real level that remains positive, there is still considerable scope to cut interest rates.

The major reservation against a drop of more than 100 basis points at 12:00 GMT on Thursday would be fear of a run on sterling. By “run”, analysts mean a sell-off that destabilizes other markets like Gilts and stocks. Black Wednesday, September 16, 1992 when officials were unable to keep sterling within its prescribed boundaries in the ERM, a joint float that pre-dated and prepared European aspirants for the euro, was a “black” day only because it was deeply humiliating to the Conservative government and caused it to lose the next general election in 1997. From an economic standpoint, Black Wednesday ushered in a long period of economic expansion with low and stable price inflation. Over the 4-1/2 months following that day, the Bank of England cut its benchmark rate from 10% to 6%, while Fed and Bundesbank rates were steady. The pound fell 20.9% against the dollar and 14.2% against the mark by end-January 1993, but that depreciation did not create an inflation problem, nor hurt the economy in any other discernible way. On the contrary, British competitiveness was lifted to a more appropriate level.

Since the 150-bp rate cut last month, sterling has dropped 6.3% against the dollar, 5.6% against the euro and 5.3% in trade-weighted terms. Trade-weighted depreciation since the start of this year amounts to slightly more than 15%, so the vulnerability of sterling is already established. The economic outlook, however, is sufficiently grim that a rate cut of 125 basis points is a risk that seems worth taking. That would be my recommendation.



One Response to “Bank of England Preview”

  1. Simon says:

    Hi Larry,

    Martin Wolf from the FT said on the news last night that there was a 1 in 5 chance that GBP could collapse by 50% from current levels.

    That would be Icelandic!!!