UK: Revised BoE Interest Rate Forecasts

Overview: Due to recent comments by members of the Monetary Policy Committee (MPC), growing financial convulsions and a bleak economic outlook, we revise our interest rate forecasts for the Bank of England (BoE). As shown in table 1, we expect the BoE cutting cycle to start in November and to continue with another five cuts into 2009, taking the Bank rate to 3.5%.

Table 1: Previous and revised BoE forecasts (current Bank rate: 5.0%)

Details: In its latest Quarterly Bulletin, BoE said that "output [is expected] to be broadly flat over the next year or so, after which growth gradually recovers. But there is a risk that the slowdown may be more pronounced ". The growth projection was revised downwards and risk was perceived to be on the downside.

BoE attaches rather large possibilities - 44% and 48% - that growth will be negative in Q1 09 and Q2 09. BoE still foresees higher inflation rates over the next few months, citing energy, food and import prices as the main drivers. CPI inflation is expected to fall back sharply to a little below the 2% target in the medium term, but considerable uncertainty surrounds this outlook. Overall, BoE thinks risks to the inflation outlook lie on the upside.

In general, BoE makes a virtue of the necessity to spell out the high degree of uncertainty surrounding both the CPI and especially the GDP outlook. It is, however, its best projection and perhaps more importantly, it does not deviate that much from market forecasts in general.

Comments made by individual members of the MPC further strengthen the case for cuts soon. Kate Barker, an external member of the MPC, said in a speech last week that "the latest developments in financial markets have now increased the downside risks" and added that "there are real dangers that the impact of these would be a downturn in the economy which is unnecessarily large and would therefore result in a large undershoot of the inflation target." Furthermore, we think that Deputy Governor Charles Bean, who also voted pre-emptively for rate cuts in 2001 and 2005, will soon vote for lower rates.

The weak economic outlook for the UK economy is further underlined by today's PMI Manufacturing numbers. The indicator fell to 41 in September from a revised 45.3 in August (revised down from 45.9). This is the lowest level recorded since the series started in 1992.

Assessment & Outlook: Following comments from the MPC on the back of recent financial turmoil and a weak economic outlook, we strongly believe that the BoE will cut rates this year. While an October cut is almost fully priced in the OIS market, we think BoE will prefer to wait until November when the Inflation Report is published. However, with the PMI number today, there is a good chance that MPC could choose to start the cutting cycle this month. Once initiated, we anticipate the BoE will continue cutting until the required amount of monetary stimulus is achieved. In our view, this will not be until the base rate is 150 bp lower.

Danske Bank
http://www.danskebank.com/danskeresearch

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