BoE's Rate Cut Risks Inflation Rise

The eagerly awaited quarter-point rate cut will shrink mortgage payments, but the bank's accompanying statement stressed coming downside risks

The Bank of England yesterday "played Santa", cutting interest rates by a quarter percentage point, to 5.5 per cent. The move prompted analysts to forecast a 5 per cent base rate by next summer, and further reductions, to perhaps 4.5 per cent, by 2009.

In an accompanying statement, the Bank's Monetary Policy Committee (MPC) signalled its concerns about the continuing credit squeeze. It said: "Conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead."

For homeowners, each quarter-point cut in the central bank's benchmark rate shaves about £31 off the monthly repayments on a mortgage of £200,000. The last change in base rates was an increase of 0.25 percentage points to 5.75 per cent, in July.

The US Federal Reserve is widely expected to follow the Bank of England and reduce rates next week.

Yesterday's cut follows a sustained campaign from retailers and the property sector. A series of companies have cut profits forecasts in recent weeks, warning of a squeeze on consumer spending. House prices have also begun to fall, reflecting the increasing cost of borrowing.

In addition, conditions in money markets have continued to tighten in recent weeks, with inter-bank rates now at nine-year highs. End-of-year reporting needs and the banks' desire to "hoard cash" to repair battered balance sheets are the immediate causes for the tightening in conditions. However, the persistence of the "disconnect" between the policy rate and market rates is vexing Bank officials.

The Bank had already signalled, via its Inflation Report last month, that it was going to cut rates in 2008 in any case, and the MPC may have felt that bringing the adjustment forward by a month or two would help sentiment in financial markets and among households. Recent days have seen extremely weak surveys of consumer confidence and the longest run of house-price falls since the mid 1990s.

The National Institute for Economic and Social Research yesterday downgraded its growth forecasts for the last quarter of this year, though the Office for National Statistics reported encouraging progress in the manufacturing sector, a bright spot in an otherwise gloomy scene.

The Bank's move was widely welcomed yesterday, though the London stock market fell back slightly because some investors had anticipated a larger rate cut.

Alan Clark of BNP Paribas said: "Instead of just talking about it, the MPC has been brave enough to act pre-emptively. For some time the MPC has flirted with the idea of acting early to avoid the need to move rates by a greater amount at a later stage." Michael Coogan, Director General of the Council of Mortgage Lenders added: "This will reduce the risk of payment shock for the 1.4 million borrowers coming off fixed rates in the next year."

Analysts are eagerly awaiting the minutes of the MPC's proceedings, which will reveal how the nine-member body voted, and whether the Governor of the Bank, Mervyn King, was in a minority opposing a cut.

The pound fell to a two-month low against the dollar after the rate cut, in contrast to the renewed strength of the euro after the European Central Bank (ECB) decision to hold rates at 4 per cent, with the president of the ECB, Jean- Claude Trichet, threatening to raise rates if an oil-driven jump in inflation provokes wage and price rises.

There is "strong short-term upward pressure on inflation", M Trichet said, adding that the ECB "will not tolerate second-round effects". Inflation in the 13-nation Euro area accelerated to 3 per cent last month.

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