The Bank of England reduced British interest rates by 50 basis points from 6.75 per cent to 6.25 per cent yesterday in response to the slowdown in the economy and the prospect of below-target inflation.
Although the financial markets had priced in a 0.25 per cent reduction, the decision by the Bank's monetary policy committee (MPC) to go for a larger 0.5 of a percentage point cut caused little surprise in view of the rate reductions in Europe and the USA.
The reduction is the third in as many months and brings British rates down from their peak of 7.5 per cent during the summer when inflationary pressures were still considered to be strong. Since then, however, underlying year-on-year inflation has hit the government's 2.5 per cent target for three months in a row and the economic slowdown has diminished the prospects of a revival of inflationary pressures next year.
Commenting on the further rate cut, the bank said that "the prospect for global activity appears to have weakened and commodity prices have fallen further".
"In the UK, economic growth in the third quarter was revised down and surveys of activity have continued to indicate a deterioration across the economy," the bank noted in its statement. While the economy is slowing down sharply, the bank sought to emphasise that the labour market remained "tight" and that financial indicators remained relatively strong.
Taking these factors into account, the MPC "judged that the downside risks to both activity and inflation have increased and therefore reduced interest rates by 0.50 per cent to keep prospective inflation on track to meet the 2.5 per cent target".
The decision to opt for the larger reduction rather than the 0.25 of a percentage point expected by the market suggests the MPC has signed up to the new consensus fearing deflation rather than inflation.
Even at the new level of 6.25 per cent, British rates are among the highest in industrialised countries and are more than double the prospective 3.0 per cent euro zone rate. Sterling was barely changed at 2.76 deutschmarks after yesterday's rate reduction and the currency will continue to be buoyed on the foreign exchanges until short-term British rates converge more closely with European rates.
Most City economists are forecasting further reductions in British rates to 5.5 or 5 per cent by the end of next year. Even at those levels, though, British rates will still be significantly higher than euro-zone rates maintaining sterling at high levels.
