BoE Eases Up on the Monetary Policy Accelerator Pedal - But Only a Little

Although the MPC took its foot slightly off the monetary policy accelerator pedal today, they still delivered a dramatic 100bp cut to 2.0%. The Bank of England already embraced the case for aggressive monetary policy easing in the context of the November Inflation Report round, undertaking an astonishing 150bp cut early last month. Since early October, as leading economic indicators have tumbled to decade lows and inflationary pressures have all but evaporated, the Bank Rate has been slashed 3 percentage points as the BoE has acknowledged the severity of the current downturn and attempted to get ahead of the curve.
 
The statement released alongside the decision noted that the "downturn has gathered pace". This has been most dramatically highlighted this week with the closely watched purchasing managers' survey data. Our composite PMI index, which combines the services, manufacturing and construction sectors, fell roughly three full points in November to a fresh record low of 36.5. This signals that the decline in GDP is likely to intensify in 4Q, having already slumped 0.5% qoq in 3Q. We look for a fall of at least 0.8% qoq in the current quarter with GDP in 2009 as a whole dropping 2%.
 
The MPC attempted to mitigate some of the widespread gloom, noting that the significant depreciation in sterling should help "moderate the impact of weaker global growth" on the UK economy. The statement also referenced the government's recent Pre-Budget Report announcement of a 1% of GDP fiscal stimulus---delivered mainly via a 2.5 percentage point cut to the VAT rate. While the fiscal stimulus may take the edge off the downturn and that the notable improvement in competitiveness will help exporters once global demand recovers---unlikely any time soon---we believe the most fundamental aspect remains whether a highly stimulative monetary policy stance actually is able to deliver its magic in the form of a lower cost of borrowing to the economy. On this score, the outlook is highly uncertain. Banks remain unwilling to lend in an environment of rising risk as the credit cycle turns decisively negative. Rapidly rising unemployment over the coming year will lead to a surge in repossessions, bankruptcies and loan failure, a hardly encouraging environment for lenders. The MPC statement once again warned that conditions in money and credit markets remained "extremely difficult" and that "it was unlikely that a normal volume of lending would be restored without further measures."
 
The statement repeated the November Inflation Report warning that there exists a "substantial risk" of undershooting CPI inflation. In central bank speak, this signals that the BoE will probably continue to ease rates aggressively in coming months. The MPC did note that the decline in market interest rates and the further depreciation in sterling has "raised the profile for inflation". However, it also acknowledged that the profile for economic growth has been even worse than anticipated in early November, which would have the impact of lowering the outlook for inflation. Moreover, the MPC warned  that the decision to temporarily cut the VAT to 15% would introduce "some  volatility"  into the inflation profile.

We expect that the BoE will likely follow up with 50bp cuts in both January and February, taking rates to a trough of 1.0%. We see some chance that the BoE could move to 1.0% in January already. Although it is not our central scenario at this stage, we see a risk that rates could drop below 1% during 2Q  and that the BoE is then later forced to adopt the Federal Reserve template of quantitative easing in the form of buying gilts and MBS, in our view.

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