Bank of England and European Central Bank Poised to Cut Interest Rates Again at 6 November Policy Meetings

The question is not will the Bank of England cut interest rates on Thursday, rather how big will the cut be?

We expect the Bank of England to match the 50 basis point cut it made on 8 October, thereby taking interest rates down from 4.50% to 4.00%. However, given the very serious and still-growing danger that the economy could suffer an extended, deep recession, we believe that there is a compelling case for the Bank of England to "get on with the job" and deliver a full one-percentage-point cut from 4.50% to 3.50%.

News that the economy contracted 0.5% quarter-on-quarter in the third quarter was a real bolt from the blue, with the outturn being worse than even the most pessimistic forecast in various surveys. While the contraction in the third quarter does not put the United Kingdom officially into technical recession yet (this is defined by two successive declines in quarter-on-quarter growth and the economy was flat in the second quarter), the depth of the decline means that we are there to all intents and purposes. Furthermore, there can be no doubt that further marked GDP contraction will occur in the fourth quarter.

Indeed, the prospects for the fourth quarter look even more worrying, as latest data and survey evidence relating to service sector activity, manufacturing, the consumer, unemployment, investment intentions, and the housing market remain overwhelmingly bearish.  On top of this, the deepening of the financial crisis in mid-September is bound to have a significant negative impact on the real economy in the fourth quarter and beyond. While the government has responded with some bold moves to tackle the crisis, these will take time to take effect, even if they are successful. Similarly, the Bank of England's 50-basis-point interest rate cut on 8 October will only have a very limited stimulative impact, particularly in the near term, given current, still-very-tight credit conditions.

Meanwhile, inflation is rapidly becoming yesterday's problem, even though consumer price inflation actually climbed to a new high of 5.2% in September, which took it even further above the Bank of England's 2.0% target rate. September's rise in inflation was primarily due to some final utility price increases being implemented, and all the evidence points to inflation falling back very sharply over the coming months. Indeed, inflation seems set to move below 2.0% in the second half of 2009, and it could well undershoot by a substantial margin.

Prolonged, very weak economic activity, faster rising unemployment, and extended tight credit conditions will increasingly dilute underlying inflationary pressures. Indeed, there are growing signs in the latest surveys and producer price data that companies' pricing power is now waning, while the latest YouGov/Citigroup survey showed a sharp retreat in inflation expectations in September. Along with rising unemployment, this dilutes any lingering fears that wages could yet move significantly higher as a consequence of the elevated inflation levels seen so far this year. Meanwhile, available evidence clearly points to wage moderation continuing. On top of this, the recent marked retreat in oil and commodity prices will obviously bring consumer price inflation down, along with favourable base effects. These factors should substantially outweigh the inflationary impact of the weaker pound.

Given this backdrop, we expect the Bank of England to cut interest rates by 50 basis points from 4.50% to 4.00% next Thursday, and to then follow this with another 50-basis-points cut to 3.50% in December. Given the serious straits that the economy is in, we believe there is a strong case for the MPC to be bold and cut interest rates from 4.50% to 3.50% in one move on Thursday. Further out, we expect interest rates to come down to 2.00% in 2009. This reflects our belief that the economy will contract up to, and including, the third quarter of 2009 before stabilizing. We now expect GDP to contract by 1.5% overall in 2009.

EUROPEAN CENTRAL BANK ALSO EXPECTED TO CUT INTEREST RATES BY 50 BASIS POINTS, FROM 3.75% TO 3.25%, ON THURSDAY

European Central Bank (ECB) President Jean-Claude Trichet indicated this week that the bank could cut interest rates again at its 6 November policy meeting, following the 50 basis point that it enacted on 8 October, which took its key interest rate down from 4.25% to 3.75%. Other senior ECB officials have since echoed Trichet's comment. Given the recent stream of dismal news on the Eurozone economies, still serious financial sector problems and mounting evidence that Eurozone consumer price inflation is firmly on the retreat, we expect the ECB to bring interest rates down a further 50 basis points to 3.25% on Thursday.

It seems hard to believe now, but it was only in July that the ECB raised its key interest rate from 4.00% to 4.25% to counter what it saw as serious threats to medium-term price stability across the Eurozone. Inflation is now very much yesterday's threat, and the ECB is only too well aware that extended, deep recession is now the major danger facing the Eurozone economies. Indeed, the ECB now acknowledges that consumer price inflation is likely to fall back below its medium-term target level close to 2.0% in the second half of 2009 and could end up much lower still if recession takes a firm grip. This is currently a rapidly growing possibility. Eurozone consumer price inflation has already retreated from a record high of 4.0% in June/July to 3.2% in October.

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 are also now clear signs that underlying inflationary pressures are diminishing as weaker economic activity dilute companies' pricing power. For example, the composite output price index of the purchasing managers' manufacturing and service sector surveys fell back markedly in October to be at its lowest level since the end of 2005.  Furthermore, the European Commission's business and consumer confidence survey for October showed a third successive, and deeper, fall in the selling-price expectations of manufacturers. Consumers' inflation expectations edged up in October after falling markedly over the previous three months, but at +19, the index was still well down from +31 in June and below its long-term average of 23.

Latest Eurozone data and survey evidence have been dismal, indicating that the heightened financial crisis is already having a serious dampening impact and is significantly intensifying the danger of deep, extended recession. Business and consumer confidence fell off a cliff in October, with the European Commission's economic sentiment index for the Eurozone plunging to it slowest level since late-1993. Meanwhile, the October purchasing managers' surveys showed manufacturing activity contracting at its fastest rate since the survey started in 1997, and service sector activity declining at the deepest rate for seven years. The surveys were extremely weak across the board showing sharply contracting total orders, exports and backlogs of work, as well as increasingly falling employment.

Meanwhile, a sixth successive rise in Eurozone unemployment in September reinforces belief that workers' bargaining power will be increasingly undermined and that this will lead to wage moderation. Favorable base effects will also bring Eurozone inflation down over the coming months.

Given current sharply deteriorating Eurozone economic activity and increasingly diminishing inflationary pressures, we expect the ECB to cut interest rates by a further 50 basis points from 3.75% to 3.25% on Thursday. Further out, we now see Eurozone interest rates coming down to 2.25% in 2009, and very possibly even lower.