Bank of England's Race to Zero Speeds Up

The Bank of England is set to make history again Thursday, with the Monetary Policy Committee (MPC) widely expected to cut rates to an all-time low. Economists are predicting that the Bank will cut rates for the fifth month in a row by half a percentage point to 1 percent, the lowest level since the Bank was founded in 1694.

AP Bank of England Governor Mervyn King

Rates currently stand at 1.5 percent, after the rate-setting committee voted 8-1 for a 50 basis point cut on January 8th. Since the last MPC meeting in January, along with a snow storm, the UK economy has been battered and bruised by bleak economic headwinds.

With a 1.5 percent fall in GDP in the fourth quarter of last year - the biggest contraction in almost 30 years - the UK is now officially in recession and the IMF is warning that it will be the worst hit of the G7 nations by the global financial crisis.

Output would shrink by 2.8 percent this year, the biggest drop since the Second World War, the IMF said. Sterling also continues to show worrying signs of weakness. The fear of the fall in sterling was one reason that the MPC considered leaving rates on hold, according to minutes from the last meeting, and suggested that the Bank may be more reluctant to cut rates as dramatically as in the past.

But sterling may no longer be such a big concern, after it staged a modest recovery over the past few weeks, Simon Derrick, Head of Currency Research, Bank of New York Mellon said. In fact, the euro zone is increasingly facing its own problems, with fears of more sovereign downgrades and sterling could actually stage a recovery against the euro, Derrick believes.

Meanwhile, arch-dove David Blanchflower said last week that he believes monetary policy needs to be "loosened further and quickly." Blanchflower voted for a 1 percentage point cut in January and has been calling for rate cuts ever since the crisis first began. 

But, as Stephen Lewis from Monument Securities notes, it seems his "instinct told him the committee should be easing, even if careful analysis of the data indicated that the massive cut in interest rates already implemented had no discernible impact on the economy."

Given that there seems to be no improvement in the UK economy since the last meeting, moving closer to zero might leave the Bank with less leeway for the future, Derrick said, adding that there is a good chance that quantitative easing will be the next card the Bank plays.

We are "no longer in a world of expanding foreign exchange reserves therefore if there is less demand for bond issues, by definition the Bank will become the buyer of last resort and quantitative easing is the most affective way to afford government debt," he explained.

This month, the MPC will also have seen the quarterly inflation report - to be published on February 11 - which is expected to show continued decline in consumer price inflation. However, whilst the report is normally critical, UK Chancellor Alistair Darling's comments late last year that the focus was no longer on inflation were "the green light for the MPC  to focus on growth, so the report is unlikely to create any obstacles to cutting rates" according to Derrick.

But not everybody is that relaxed. In a research note last week, Morgan Stanley analysts raised the specter of the "black swan event of very high inflation or even hyper inflation" around the world, forecasting UK rates to stay on hold this time round. They also believe the markets are probably pricing in too many rate cuts.

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