Further deep cuts in benchmark UK interest rates look extremely likely following the Bank of England's projection yesterday that recession will drive benchmark inflation below 1% within two years.
Further deep cuts in benchmark UK interest rates look extremely likely following the Bank of England's projection yesterday that recession will drive benchmark inflation below 1% within two years.
Economists now expect base rates to fall from 3% to 1.5% by the middle of next year - taking their median forecast yesterday - below the 2% level which is to date the lowest since Bank of England records began in 1694. A significant minority of economists expects base rates to end 2009 at just 1%.
The pound plummeted in the wake of the latest quarterly inflation report from the Bank yesterday. The euro rocketed to 84.11p, its highest level against sterling since its launch in 1999 and nearly 2p higher than its previous all-time high of 82.14p struck on Tuesday.
Sterling dived below $1.50. It fell as far as $1.4897 - its weakest since June 2002.
The sub-1% inflation level now being projected, on the chosen two-year time horizon of the Bank's Monetary Policy Committee, is less than half of the 2% target set by the Treasury. The MPC is now forecasting UK gross domestic product in the first quarter of 2009 will be about 2% lower than a year earlier.
Benchmark annual UK consumer prices index inflation stood at 5.2% in September.
Bank of England Governor Mervyn King said it was "very likely" that the old all-items retail prices index measure of inflation, which stood at 5% in September and takes in housing-related costs, would turn negative next year. And yesterday's report flags a significant probability that even the CPI measure will turn negative.
King shrugged off accusations that the MPC had been too slow to cut interest rates, declaring: "The world has changed."
One of the MPC's nine members, David Blanchflower, pushed in vain for months for further reductions in base rates after April's cut to 5%. The MPC did not cut again until October 8, when it reduced base rates by a half-point in action co-ordinated with other major central banks around the world. Declaring it "very likely" the UK economy entered a recession in the second half of this year and noting the MPC's latest central projection for "output to decline over the next year", King said it was "perfectly reasonable" for the UK Government to provide a fiscal stimulus.
King said yesterday: "There are two changes which mean that in these circumstances it is reasonable to think about fiscal policy as a complement to monetary policy. One is credit constraints on households, which make fiscal policy likely to be more effective, and secondly the fact that the transmission mechanism of monetary policy has been in part impaired through the banking crisis and it's precisely in those circumstances that fiscal policy has a role alongside monetary policy.
"But it still has to be temporary. And it still has to be consistent with a medium-term framework which shows a sustainable path for tax and spending. If not, the benefits can be lost in terms of higher long-term interest rates."
The Treasury announced yesterday that Chancellor Alistair Darling would deliver his pre-budget report on November 24.
King emphasised yesterday's growth and inflation projections did not take account of any new tax cuts or boost to public spending which might be delivered.
A poll taken by Reuters, after the latest projections from the MPC, showed the median forecast among economists is now that UK base rates will fall to 1.5% by mid-2009. This forecast had been 2% in a poll taken last week in the immediate wake of the MPC's astounding one-and-a-half-percentage-point cut in UK base rates to 3%.
The MPC's latest growth and inflation projections are very similar whether they are based on benchmark interest rates remaining at the 3% level to which they were slashed last week or on market interest-rate expectations before this cut was announced. Financial markets had been projecting base rates would fall from an average 4% in the fourth quarter of this year to around 2.75% in the second half of 2009, before picking back up to around 4% by 2011.
The Bank lays out the bleak near-term UK outlook in yesterday's report, declaring: "There has been a marked deterioration in the outlook for domestic and global economic activity. Instability in banking and financial markets intensified to levels not seen for almost a century. And, in the United Kingdom, official estimates of GDP growth, business surveys and reports from the Bank's regional Agents all weakened sharply.
"The economy probably entered recession in the second half of 2008 and output is likely to contract further. Consumer spending faltered in the second quarter under the weight of tighter credit and the squeeze on household budgets. Residential investment continued to fall rapidly and prospects for business investment weakened."
The Bank also noted that, since its August inflation report, share prices had fallen by about one-quarter in advanced economies and by even more in many emerging markets.
King was at pains yesterday to draw a distinction between the position in the UK and that in Japan, which suffered a "lost decade" as authorities reacted too slowly to the country's 1990s banking crisis.
He said: "We have taken action much earlier than was taken in the case of Japan and I think you can see around the world there is a commitment to take the action that is necessary."
Bank of England deputy governor Charles Bean attempted to highlight parallels with the far less nasty Swedish experience.
He said: "The profile is actually not that dissimilar from the Swedish experience if you look at what happened there. The downturn really started in the second half of 1992 and the Swedish authorities moved quite quickly to essentially nationalise their banking system and, by 1994, the Swedish economy was recovering."
In yesterday's report, the Bank predicts that year-on-year growth in UK GDP will have bounced back to a rate slightly above its long-term trend of around 2.5% by the end of the two-year time horizon.
Of the 51 economists polled by Reuters, 14 predicted base rates would be at 1% by the end of next year. Eighteen forecast they will be at 1.5%, with one economist predicting they will be at 1.75%, 16 projecting an end-2009 level of 2% and two going for 2.5%.
Of a larger sample size of 57 economists, 36 predict the MPC will cut UK base rates by a further half-point to 2.5% when it concludes its next two-day meeting on December 4. Twelve forecast a full-point cut and two predicted a reduction of three-quarters-of-a-percentage point, with six projecting a no-change outcome. One tipped a 1.5-point cut.
UK base rates have fallen from 5.75% since last December.
The Bank, in its inflation report, dwells on the growing strain on household finances and acknowledges this problem will get worse as unemployment rises.
It says: "Over the past year, there has been a small increase in payment difficulties among mortgagors. And the percentage of unsecured debtors reporting that their debts were a heavy burden rose slightly to 14%, compared with 12% in 2007.The primary cause of repayment problems cited by survey respondents was higher-than-expected household bills.Moreover, the sharp deterioration in the macroeconomic environment since the August report is likely to increase the pressure on household finances further."
It adds: "Most importantly, labour market conditions have started to deteriorate: unemployment has risen and the number of job vacancies has fallen. And falls in house prices have eroded cushions of housing equity over the past year.
"While the reductions in Bank Rate in 2008 should help to ease the burden of debt repayments, it is likely that there will be a further increase in households' repayment difficulties in the near term. The MPC will continue to monitor indicators of household distress closely to judge the extent of those problems."
