Thursday sees the Bank of England announcing its interest rate decision for January, while the ECB will deliver its decision on 15 January. Both central banks are under intense pressure to deliver major cuts, but the Bank of England seems more willing to oblige than the ECB.
Bank of England Poised to Slash Interest Rates
It seems a stone-dead certainty that the Bank of England will deliver another hefty interest rate cut next Thursday. We are forecasting a 75-basis-point cut from 2.00% to 1.25%, but it is very possible the Monetary Policy Committee (MPC) could produce a third successive reduction of 100 basis points or more. With the recession deepening, credit conditions remaining worryingly tight, and inflationary pressures retreating sharply, there is intense pressure on the MPC to bring interest rates down sharply further.
Significantly, the minutes of the December MPC meeting suggested that another substantial interest rate cut in January is very much in the cards. Not only did all nine MPC members vote in favour of slashing interest rates by 100 basis points from 3.00% to 2.00% at the December meeting, but the minutes revealed that the committee considered that "a cut of at least 100 basis points was needed," and they discussed whether a larger cut was warranted. The MPC considered that without a further interest-rate reduction, consumer price inflation would likely substantially undershoot its 2.0% target over the medium term given the sharply deteriorating U.K. economic performance and outlook; growing spare capacity; the ongoing dislocations in the financial markets; and the worsening, synchronized downturn in global economies.
The decision not to go for an even bigger cut than the 100 basis points enacted in December was partly due to concern that this could lead to an excessive fall in sterling and could also further undermine confidence in the economy. It was also considered questionable whether there was much to be gained in cutting interest rates by more than 100 basis points given that they had been cut from 5.0% to 2.0% in eight weeks, and this would take time to feed through to boost the economy.
Since the December MPC meeting, the U.K. downturn has continued to deepen and credit conditions have remained extremely tight. The third-quarter contraction in GDP has been revised to an even deeper 0.6% quarter-on-quarter (q/q) from the earlier estimate of 0.5%, and indications are that the fourth quarter probably saw a markedly sharper contraction probably of around 1.0% q/q. Latest data and survey evidence are extremely weak across the board, be it related to service sector activity, manufacturing, construction, retail sales, or business investment. Furthermore, unemployment is picking up at an alarming rate.
Meanwhile, there is a very real likelihood that the United Kingdom will see a period of deflation in 2009, even though consumer price inflation has so far only fallen back to 4.1% in November from September's peak of 5.2%. Consumer price inflation will be brought down substantially over the coming months by heavily contracting economic activity, pay moderation, sharply lower oil and commodity prices, waning food prices, and favorable base effects. December's value-added tax reduction will also sharply reduce inflation. These factors will markedly outweigh the inflationary impact of the very weak pound. Consequently, U.K. consumer price inflation is likely to turn negative for a time in the second half of 2009, and we forecast it to average just 0.6% over 2009.
Ongoing evidence that the recession is deepening, credit conditions remain punitively tight, and inflationary pressures are retreating sharply underpins our belief that the Bank of England will reduce interest rates by at least a further 75 basis points from 2.00% to 1.25% next Thursday. While an even bigger cut could well occur, wesuspect theMPC may prefer tomoderate the pace at which it is cutting interest rates as they near zero and allow the previous cuts more time to feed through and take effect. Sterling's current serious weakness and vulnerability may also deter the Bank of England from cutting by more than 75 basis points next Thursday. Further out, we expect interest rates to fall to a low of 0.50% in the second quarter of 2009 and then stay there for the rest of the year. However, it is far from inconceivable that interest rates could go all the way down to zero.
Will or Won't the European Central Bank Cut Interest Rates
While it is odds-on that the Bank of England will deliver another substantial interest rate cut next Thursday, it is far from certain that the European Central Bank (ECB) will cut interest rates at all when it next meets on 15 January.
The ECB has kept its cards very close to its chest regarding its intentions at its 15 January meeting, and has indicated some reluctance to cut interest rates sharply further after reducing them by 175 basis points between October and December, from 4.25% to 2.50%. In particular, ECB president Jean-Claude Trichet has highlighted that the full effect of the recent 175-asis point r-eduction in rates has far from fully filtered through to affect economic activity. Trichet has also repeatedly stressed that the ECB never pre-commits to future monetary policy decisions. In contrast, Trichet and other senior ECB policymakers strongly hinted that interest rates would be cut in the run-up to the ECB's December meeting.
Even so, Trichet is acknowledging that the risks to growth are on the downside, and a number of other ECB members have hinted that a rate cut is possible on Thursday of next week. Latest Eurozone data and survey evidence have generally been dire, and it looks certain that the Eurozone recession deepened markedly in the fourth quarter of 2008 after GDP contracted by 0.2% q/q in both the second and third quarters. For example, Eurozone business and consumer confidence plunged in recent months and are at their lowest levels for 15 years, while the composite Eurozone services and manufacturing purchasing managers' index showed activity contracting for an eighth successive month in December, and at the fastest rate since the series started in 1998.
On top of this, credit conditions remain uncomfortably tight across the Eurozone, and there are signs that this is increasingly weighing down on businesses and consumers.
Meanwhile, Eurozone consumer price inflation seems certain to have fallen sharply further in December, after plunging to 2.1% in November from 3.2% in October and the June/July record high of 4.0%. Indeed, Eurozone inflation in December is likely to have fallen below 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 clear evidence that underlying inflationary pressures are now diminishing appreciably as very weak economic activity hits companies' pricing power hard. On top of this, consumers' inflation expectations have fallen back sharply, while rising Eurozone unemployment is diluting workers' ability to push for higher wages.
In addition, the euro has firmed markedly in recent weeks, rising back up to US$1.40, after dipping below US$1.25 in November and setting a new lifetime high close to parity against sterling. This will further limit inflation, as well as hurt Eurozone growth prospects. If the ECB fails to cut interest rates on Thursday, it could well send the euro higher still.
There is significant speculation that the ECB could hold off from cutting interest rates at its 15 January meeting, but instead pave the way for a cut in February. Much could yet depend on the data and survey evidence in early January. We expect it to be pretty dismal overall, showing that the Eurozone is in marked recession. At the same time, further evidence is likely to emerge that Eurozone inflationary pressures are retreating sharply.
Consequently, we believe the ECB is more likely than not to cut interest rates at its 15 January meeting, but a 50-basis-points reduction from 2.50% to 2.00% seems the maximum it will be prepared to deliver. Indeed, it is very possible the ECB will only trim interest rates by 25 basis points to 2.25%. Further out, we believe the ECB will eventually bring interest rates as low as 1.00% in the first half of 2009 as the Eurozone suffers sharp recession. Interest rates are then seen staying at 1.00% through the rest of 2009.