Tomorrow's Bank of England Inflation Report

February 10, 2009

The U.K. quarterly Inflation Report can be a powerful interest rate signaling device as the November review aptly demonstrated.  The Bank of England had cut its benchmark rate by 50 basis points in October and by an eye-popping 150 basis points to 3.0% earlier in November. Nevertheless, the last Inflation Report bluntly forecast a drop in consumer price inflation to 1.5% by 4Q09 and 0.8% by 4Q10, that is more than a full percentage point below target in the medium term, if the benchmark were to remain fixed at 3.0%.  With such an estimate, the dye was cast for another 200 basis points of rate cuts in the coming three months, administered in doses of 100 bps in December, 50 bps in January, and 50 bps to 1.0% earlier this month.  Such easing would normally be presumed to lift projected medium-term inflation closer to its target of 2% in tomorrow’s central bank report.

However, the Bank of England is up against headwinds that are much more powerful than imagined three months ago and must run to stand still.  The November Report had assumed negative growth in the first half of 2009 of some 1.75% and a V-shaped recovery to more than 2% positive growth by late 2010. Real GDP in fact tumbled 5.9% at a seasonally adjusted annual rate last quarter, and a rapid rebound isn’t going to happen.  The fears are that growth in 2009 may be as weak as negative 3% and that the business cycle is shaped like a U or an L instead of a V.  The Bank of England in November projected sub-target inflation as far as the eye could see despite gloomy assumptions about sterling.  On the contrary, the pound has recovered about 7.5% since January 22nd on a trade weighted basis.  It is up 11.7% against the euro since the first trading day of 2009 and is 8.6% stronger against the dollar since touching a low of $1.3502 on January 23rd.  Even though oil has fallen further, the combination of an exchange rate that is not as low as anticipated and growth that has tumbled more dramatically than assumed conveys more, not less, deflationary risk.

There’s no question that that the Bank Rate must and will be lower further.  This is no time to worry about damaging money markets with a target rate that is near zero.  Since January 22nd, interest rates are 50 basis points lower, but sterling appreciation is likely to pack the potential drag that will more than neutralize that most recent rae cut.  It doesn’t help the prognosis for growth either that 10-year Gilt yields are 82 basis points above the end-2008 level.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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