BoE Set to Boost Money Supply as Rates Near Zero

The Bank of England looks set to cut interest rates to close to zero Thursday and announce it will start boosting the money supply to resuscitate the economy as conventional monetary policy measures lose their edge.

The Treasury will set out how much money the central bank could create and other details in an exchange of letters between finance minister Alistair Darling and BoE Governor Mervyn King.

Analysts reckon the initial limit could be as much as 100 billion pounds ($141 billion).

Policymakers will likely exercise caution as they enter the uncharted waters of quantitative easing (QE) and the first asset purchases will probably be small to give them a chance to see how the process is working.

A Reuters poll last week showed 54 out of 62 economists expected the Monetary Policy Committee to cut interest rates from their current 1 percent when their monthly meeting ends at 12 p.m. London time on Thursday.

Forty-six of those polled forecast the MPC would trim borrowing costs by half a percentage point to a record low of 0.5 percent.

However, a significant minority reckoned there was a risk of a smaller reduction or no cut at all.

Minutes to the MPC's meeting last month showed policymakers were concerned that cutting rates further could squeeze banks' profits and lead them to further restrict lending, which in turn would hamper a recovery.

Still, uncertainty about the effectiveness of QE may encourage them to cut rates anyway to boost confidence.

"We would have expected some degree of expectations management from the MPC were the prevailing view that a rate cut would be a bad idea," said Philip Shaw, economist at Investec.

New Tools Needed

Policymakers have been warning they will have to resort to unconventional measures to dig Britain out of recession and prevent deflation as they run out of room to cut borrowing costs.

They have said a lack of money in the economy poses the biggest threat to any recovery.

Britain slipped into recession for the first time in nearly 20 years in 2008 and the BoE predicts the downturn will worsen in the first few months of this year.

Sharon Lorimer

More worryingly, it forecasts inflation will be well below its 2 percent target in two years' time and policymakers have highlighted the risk of deflation, a broad-based drop in the level of prices which could trigger a dangerous downward spiral in demand.

The central bank has already made a cautious start in buying commercial paper from banks under its Asset Purchase Facility, but this is financed by issuing Treasury bills.

Last month, the MPC voted unanimously to seek government approval to use the APF to buy gilts and commercial securities using newly created money, saying that should help the economy by encouraging banks to lend more to households and businesses.

A similar policy was tried in Japan in the early part of this decade with limited success.

But with interest rates around the world close to zero and the world's major economies in recession or near it, central banks are wondering what else they can do.

As speculation swirls about the extent of any purchases, some economists have urged the BoE to act boldly.

"To alleviate the recession, it is important that the quantitative measures are forceful and decisive. It is important to avoid undue timidity," said David Kern, chief economist at the British Chambers of Commerce.

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