Bank of England and European Central Bank under Pressure to Deliver Deep Interest Rate Cuts on 4 December

28 Nov 08

It is odds-on that both the Bank of England and European Central Bank will deliver interest rate cuts at their policy meetings on 4 December. The key question is how big will these interest rate cuts be.

The Bank of England is poised to reduce interest rates substantially further on Thursday, The burning question is just how big will this cut be. A 50-basis-point interest rate cut from 3.00% to 2.50% seems the absolute minimum that the Bank of England will deliver on 4 December. We believe that there is a very strong chance that the Monetary Policy Committee (MPC) will slash rates by a further 100 basis points and take them down to 2.00%. Much could yet depend on just how bad the data and survey evidence are over the next few days; although the clear serious weakness of the economy and sharply retreating inflationary pressures provide strong grounds for another large interest rate cut anyway.

The minutes of the November meeting of the MPC certainly opened the door very wide for another sharp interest rate cut in December. Not only were all nine MPC members in favour of slashing interest rates by 150 basis points from 4.50% to 3.00% in November, but they even considered that a cut "possibly in excess of 200 basis points" might be needed to try to ensure that consumer price inflation did not undershoot its 2.0% target over the medium term given the sharply deteriorating U.K. economic performance and outlook, the intensification of the financial crisis, and the worsening global economic environment.

Since the November MPC meeting, the U.K. economy has continued to deteriorate markedly and credit conditions have remained extremely tight. Meanwhile, consumer price inflation retreated much more sharply than expected in October (to 4.5% from 5.2% in September); oil and commodity prices have fallen back further still; and latest data and survey evidence have revealed sharply diminishing company pricing power, substantially lower inflation expectations, and ongoing wage moderation. The only significant inflation source now is the weakness of the pound, but this is being substantially outweighed by other factors.

One of the reasons why the MPC did not enact an even bigger interest rate cut at its November meeting was that the committee wanted to see the government's fiscal plans in the Pre-Budget Report. While the government announced a £20 billion fiscal stimulus package and unveiled sharply higher public borrowing over an extended period, this does not appear to stand in the way of further substantial cutting of interest rates by the Bank of England. In his recent appearance before Parliament's Treasury Select Committee, Bank of England Governor Mervyn King indicated that the government's fiscal measures announced in the Pre-Budget Report met the Bank of England's desires, through enacting temporary measures to stimulate the economy and mapping out a path to fiscal sustainability (although the MPC considered this would be hard to achieve).

Indeed, the comments by Mervyn King and his MPC colleagues to the Treasury Select Committee generally reinforced belief that another major interest rate cut is likely on Thursday. King's statement indicated that the Bank of England now expects consumer price inflation to return to its 2.0% target level early next year. This is earlier than envisaged in the November Quarterly Inflation Report (which shows inflation averaging 3.2% in the second quarter of 2009), although it is obviously influenced significantly by the government's cutting of VAT from 17.5% to 15.0% from the beginning of December.

Meanwhile, although the MPC members appeared to remain hopeful that economic recovery will get underway in the second half of 2009, there was a clear awareness that there are serious downside risks to this. In particular, there is concern that ongoing very tight credit conditions could weigh down heavily on the economy. King also observed that there has been a significant fall off in demand coming into the fourth quarter. 

In addition, MPC member Charles Bean observed that because of the credit crunch "Bank Rate may need to be moved more aggressively to achieve the same impact as in more normal circumstances." Furthermore, King stated that, "We will take whatever action we feel is necessary on interest rates to steer the economy back into calmer waters. We may need to cut Bank Rate more than we would otherwise have done."

The size of the interest rate cut on Thursday could yet be influenced significantly by just how bad some influential data and survey evidence are over the next few days. The Bank of England is likely to be particularly interested in the November purchasing manager's surveys for the service sector and manufacturing. If they are as bad as we suspect they will be, then a 100-basis-point cut in interest rates from 3.00% to 2.00% looks very much on the cards. Further out, we expect interest rates to come down to 1.00% in the early months of 2009, and then stay there for the rest of the year.

EUROPEAN CENTRAL BANK

The European Central Bank (ECB) came under a fair degree of criticism for only cutting its key interest rate by 50 basis points from 3.75% to 3.25% at its 6 November policy meeting. ECB President Jean-Claude Trichet revealed that the ECB had discussed cutting interest rates by 75 basis points to 3.00%, although he indicated that the final decision to reduce them by 50 basis points to 3.25% was unanimous. Trichet also stated that he did "not exclude" another interest rate cut at the ECB's December meeting, although he stressed that the bank never pre-commits to future monetary policy decisions.

In recent weeks, the Eurozone economy has taken a distinct turn for the worse as the financial crisis, tight credit conditions, and deteriorating global activity have taken an increasing toll on already struggling and fragile economies. Eurozone GDP contracted by 0.2% quarter-on-quarter in the third quarter, following similar contraction in the second quarter, thereby putting the region into recession. Furthermore, the weakness was widespread with the Germany, Italian, and Spanish economies all contracting in the third quarter, the Dutch economy stagnating, and French growth only edging up (and somewhat surprisingly at that given the French indicators during the quarter).

The signs are that Eurozone GDP contraction will be deeper in the fourth quarter, as the latest data and survey evidence are generally horrible. In particular, the Eurozone manufacturing and service sector purchasing managers' surveys fell to respective survey 11- and 10-year lows in November. Consequently, the composite Eurozone services and manufacturing activity index showed activity contracting for a seventh successive month in November, and at the fastest rate since the series started in 1998. Orders and employment were desperately weak in November, boding ill for future activity.

In addition, already weak Eurozone economic sentiment has fallen off a cliff since September. It deteriorated sharply further in November to be at a 15-year low as businesses in particular became ever more concerned about the financial crisis and deepening domestic and global economic downturns. These factors are outweighing the beneficial impact of sharply lower oil and commodity prices, as well as the marked retreat in the euro from its July peak level just above US$1.60. Consumer confidence saw lesser deterioration in November, although it still sank to its lowest level since January 1994, as sharply increased fears over unemployment outweighed dwindling inflation concerns. Highlighting the deteriorating jobs situation, Eurozone unemployment rose for a seventh successive month in October.

Significantly, consumer price inflation is now dropping like a stone. Indeed, Eurozone consumer price inflation dived to 2.1% in November, from 3.2% in October and a mid-2008 peak of 4.0%. This was the lowest level since September 2007 and only just above the ECB's target level of "close to, but just below, 2.0%." While the retreat in consumer price inflation has been primarily due to sharply lower oil prices and a waning of the upward impact from food prices, there is now clear evidence that underlying inflationary pressures are diminishing as very weak economic activity hits companies' pricing power hard. For example, the composite output price index of the purchasing managers' manufacturing and service sector surveys indicated that prices fell in November for the first time since August 2005.

Furthermore, the European Commission's business and consumer confidence survey for November showed a fourth successive, deep fall in the selling-price expectations of manufacturers (the index was down to +1 from +20 in July). Consumers' inflation expectations for the next 12 months also retreated sharply in November; at +11, the index was well down from +31 in June and was also substantially below its long-term average of 23. On top of this, a seventh successive rise in Eurozone unemployment in October reinforces belief that workers' bargaining power will be increasingly undermined and that this will result in wage moderation

It is a nailed-on certainty that the ECB will cut interest rates again on Thursday. Indeed, ECB officials are frequently indicating that an interest rate cut is very much on the cards. With the Eurozone recession deepening and inflation heading sharply down, there is a compelling case for the ECB to be bold and slash interest rates by 100 basis points from 3.25% to 2.25% on Thursday. We suspect it may be reluctant to do so, with some ECB members indicating recently that it is best to keep some ammunition back and also voicing concern that too big a cut could hurt confidence. Therefore, we consider it most likely that the ECB will cut interest rates by 50 basis points from 3.25% to 2.75%, although we certainly would not rule out a larger reduction. Further out, we see the ECB cutting interest rates to 1.50% in the first half of 2009.

By Howard Archer
source: GlobalInsight.com