Bank of England Cuts Key Interest Rate from 5.75% to 5.50% at December Policy Meeting

The Bank of England cut its key interest rate by 25 basis points from 5.75% to 5.50% at the conclusion of the 5-6 December meeting of its Monetary Policy Committee (MPC). This was the central bank's first interest-rate cut since August 2005 and followed a cumulative 125-basis-point hiking of interest rates (in five 25-basis-point moves) between August 2006 and July 2007, which had taken the Bank of England's key interest rate up from 4.50% to a six-year high of 5.75%.

December's Interest-Rate Decision Had Been Seen as Finely Balanced

December's interest-rate decision by the Bank of England had been seen as one of the tightest calls ever, as the MPC juggled with a slowing economy and current rising inflationary pressures. Indeed, it may well have been that several MPC members entered the meeting still uncertain over their final vote on whether or not to cut interest rates. Furthermore, it had originally seemed most likely that ongoing concerns about significant inflationary pressures and considerable uncertainty as to what extent the U.K. economy is currently slowing would result in a majority of MPC members favouring unchanged interest rates at the December meeting.

This was despite the fact that the Bank of England’s November Quarterly Inflation Report had implied that interest rates would need to be cut at least twice if consumer price index (CPI) inflation was to be in line with its 2.0% target on a two-year horizon. In addition, two of the nine MPC members (David Blanchflower and Sir John Gieve) had voted for an interest-rate cut at the November MPC meeting. Nevertheless, the general impression emerging from the minutes of the November MPC meeting and their subsequent public remarks was that the other seven committee members were generally still not convinced that the economy had slowed sufficiently to warrant an interest-rate cut. Critically, the MPC has long believed that some slowdown in growth is necessary and desirable to dilute the ongoing inflationary pressures stemming from higher energy, food, and commodity prices, some signs that pay is picking up, resilient inflation expectations, and possible capacity constraints

Latest Data Has Raised Growth Concerns

However, a recent stream of markedly softer data and survey evidence relating, in particular, to the services sector, consumer confidence, and the housing market has clearly raised concern within the MPC that the economy is starting to slow markedly and that the risk of an economic hard landing has risen. In addition, the Bank of England's statement accompanying December's 25-basis-point interest-rate cut also revealed that tighter conditions in credit markets and higher market interest rates had prompted the MPC into acting. This was despite the fact that CPI inflation rose from 1.8% in September to an above-target 2.1% in October, while the Bank of England's statement also noted that "upside risks to inflation remain." Details of the December MPC vote and the minutes of the meeting have not yet been released.

Outlook and Implications

We expect the Bank of England to trim its key interest rate by a further 50 basis points in the first half of 2008. Specifically, we anticipate 25-basis-point cuts in both February (to 5.25%) and May (to 5.00%). We believe that U.K. growth will slow further over the coming months in the face of persistent serious headwinds. By restricting lending to some businesses and individuals, and by keeping short-term market interest rates well above the policy rate, the ongoing credit crunch will weigh down on growth. In particular, consumer spending is forecast to come under increasing pressure from still relatively high interest rates, tighter lending practices, muted real disposable income growth, higher debt levels, and a markedly weaker housing market. Heightened concern about the economic outlook is also likely to cause consumers to tighten their belts. Meanwhile, business investment is likely to lose significant momentum in the face of the ongoing credit crunch and increased doubts and uncertainty over the economic outlook. On top of this, global growth is also expected to be softer in 2008, which is likely to limit U.K. exports along with the lagged impact of the recent extended strength of the pound.