Page last updated at 00:49 GMT, Thursday, 4 December 2008

Bank enters uncharted territory

BBC economics editor Hugh Pym
By Hugh Pym
BBC economics editor

Bank of England
The Bank of England is expected to cut rates still further on Thursday

This is uncharted territory for the Bank of England, both for members of the Monetary Policy Committee and pundits who try to second guess their decisions.

We became so familiar with moves of quarter percentage points over many years that half point changes seemed highly unusual.

Now, after the dramatic cut of 1.5 percentage points last month, the likely outcome of this meeting is wide open. There is a range of possibilities and there can hardly be said to be one which is more likely to happen than others.

There is little doubt the Bank will want to reduce the cost of borrowing again - the question is by how much. Many City economists predict a cut of 1% from the current 3% level, with some experts calling for an even bigger reduction, on the same scale as last month's. A rate below 2% would be the lowest since the Bank of England was founded in 1694.

Dramatic action

This week's indicators from manufacturing, construction and services suggest further steep declines in confidence and output.

The UK is all but in recession. Final confirmation of that won't come until the fourth quarter output figures are published in mid January. But they seem certain to reveal another fall in gross domestic product, quite probably even sharper than the third quarter's.

The weak pound is a concern to the Bank of England

The question for the Bank is whether to move the cost of borrowing swiftly downwards or whether to keep something in reserve as recession looms. Swift and dramatic action might be seen as necessary to steer the economy away from a steep and prolonged recession. In other words, if you think rates might need to fall quite a bit further from where they are now, why hang around?

I have talked to two former members of the Monetary Policy Committee today. Professors Willem Buiter and Charles Goodhart were in no doubt that rates would move eventually to zero, or not far above it. But they both highlighted the danger of a slump in the value of sterling.

Delicate position

The pound has fallen significantly since the summer as foreign investors reappraised the prospects for the British economy. On a trade-weighted basis, it now stands at its lowest level since 1996. Higher levels of household debt than many other industrialised nations started to ring alarm bells. The UK is perceived as more risky than many competitor economies.

If the Bank of England moved too aggressively on interest rates, confidence in the currency could be further undermined. If the UK central bank was seen to be reducing the cost of borrowing more rapidly than others, incentives to hold sterling might be further diminished.

It's a delicate position for the Bank. The fall in the pound has boosted the prospect of a rebalancing of the economy away from imports towards export-led growth. But an orderly decline turning into a currency rout would be a nightmare for the authorities.

Buiter and Goodhart agree that big cuts in rates are necessary. But they warn that the currency issue may restrain the Bank of England just when restraint may be the least advisable option.

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