Bank of England in shock move cuts rate by 1.5 per cent

THE BANK of England stunned the markets yesterday by cutting its rate by 1.5 percentage points to 3 per cent, citing "marked deterioration in the outlook for economic activity at home" in the teeth of "the most serious disruption for almost a century" in the global banking system.

The move was welcomed by industry groups and economists, who said it was a signal that the bank had undertaken a sober reassessment of the UK's prospects for both economic growth and inflation. They also noted that the bank had for the first time abandoned its concerns about unnerving the markets by making unexpected changes in rates.

While most economists had forecast a cut of 0.5 to 1 percentage point, a move of this magnitude was unexpected largely because the bank's monetary policy committee, which decides on interest rates, has not made a cut of this size since it was formed in 1997.

Indeed, George Buckley, economist at Deutsche Bank, noted that, at 3 per cent, interest rates were their lowest since 1955 and only one point above their all-time low of 2 per cent, reached in 1951.

Despite the scale of yesterday's move, some economists forecast further rate cuts before the end of the year.

Yesterday's cut came after a string of data pointed to a sharply contracting economy and much-diminished prospects for inflation.

A key index showed that UK house prices are now 15 per cent below levels of a year ago - a bigger drop than in the downturn in the early 1990s, which was also over a much greater period.

New car registrations slumped by 23 per cent in September - hardly a surprise after recent anecdotal evidence from car manufacturers that they were planning to cut staff and put workers on shorter hours.

Meanwhile, activity in the services sector, which accounts for about 70 per cent of the economy, hit a record low, according to a widely watched survey.

In explaining why it made its shock move, the bank cited a sharp fall in output in the third quarter and noted that the fall had been accompanied by surveys and reports from its own regional agents indicating "continued severe contraction" in the economy.

In a hint of how severe it expected the economic contraction to be, the bank said the monetary committee deemed the unprecedented move necessary in order to keep inflation within its 2 per cent target range in the medium-term. That suggests the bank's quarterly inflation report, which is due to be published next week, will show that without big rate cuts there might be a plausible risk of deflation.

"The UK has been living beyond its means for too long and a prolonged period of pain is inevitable," said James Knightley, economist at ING, which forecasts that the British economy will contract by 1.7 per cent in 2009.

The Bank of England pointed to a contracting banking system which is gradually withdrawing from lending activities. "Since mid-September, the global banking system has experienced its most serious disruption for almost a century," the bank added.

"While the measures taken on bank capital, funding and liquidity in several countries, including our own, have begun to ease the situation, the availability of credit to households and businesses is likely to remain restricted for some time.

"As a consequence, money and credit conditions have tightened sharply. Equity prices have fallen substantially in many countries."