Economists say more easing is needed to limit a sharp deterioration in inflation, and complement a government package geared at rescuing the economy from recession.

"Following October's spectacular 150 basis point cut, the Bank of England (BoE) should take another big step in December, lowering its key rate by 100 basis points," reads a report from Desjardins. "British monetary authorities recognize that the economy will undergo a major recession; this prompted the government to announce tax measures valued at £20B to buoy the economy. The BoE's main fear is that the recession will take inflation under the 2% target. It is ready to lower its key rate as much as necessary to prevent this eventuality."

The view is consistent with a majority of economists surveyed by Bloomberg, all of which believe the central bank will follow last month's historic cut with at least a 50bp cut. The consensus is expecting a 100bp reduction in the Bank Rate.

"The minutes of the November meeting of the MPC certainly opened the door very wide for another sharp interest rate cut in December," explained IHS Global Insight's Howard Archer. "Not only were all nine MPC members in favour of slashing interest rates by 150 basis points from 4.50% to 3.00% in November, but they even considered that a cut 'possibly in excess of 200 basis points' might be needed to try to ensure that consumer price inflation did not undershoot its 2.0% target over the medium term."

Price growth in the UK slowed sharply in October, with the Office for National Statistics (ONS) reporting a 4.5% annual inflation rate compared to September's 5.2% peak.

The BOE further voiced concerns over the sharp deterioration in price growth in testimony to parliament where Governor Mervyn King told lawmakers that deflation was a possibility in the UK and that the bank is prepared to cut rates again to lower lending rates in the region.

Another consideration which economists highlight is how the BOE will complement the government's recent announcement of a £25 billion stimulus package including a 250bp cut to the value-added tax (VAT) to 15.0%, the lowest allowable level in the European Union.

"With BoE Governor King already giving his blessing to a temporary and modest fiscal boost, we do not see any major impact on future monetary policy from the Pre-Budget Report announcements," explained Bank of America economist Matthew Sharratt. "While there still remains a chance that the Bank of England could be forced to cut rates even lower to a trough of 1.0% during 2Q 2009, the size of the fiscal stimulus-a little above 1% of GDP-implies that the chance of a 1% trough in the Bank rate has diminished somewhat, in our view."

Meanwhile, market measures are mixed with the SONIA curve suggesting markets fully priced in for a 125bp reduction in the Bank Rate and the OIS market seeing an 80% chance of a 100bp rate cut.

"It's difficult to say whether FX markets have priced in a 100bp rate cut from the BOE on Friday, but I would say that 50 to 100 bps is in the price, and 100 is not fully discounted," according to one trader in London. "There are all kinds of uncertainties. It's not clear which direction the pound will go on a 100bp rate cut, but the reaction will probably sterling negative."

He also noted that at the moment, the relationship between FX and equities appears stronger than interest rates and that the euro/sterling cross is more unclear as both economies race to the bottom.

"There are days where you could have told me the day's news with absolute certainty, and I still would have gotten the FX moves wrong," he said.

A fixed income trader in London believes that short-sterling contracts are looking for a cut weaker than 100 bps, pricing in about 80 bps worth of easing, and that December contracts could move "one-for-one" with whatever the central bank does. Meanwhile, March contracts could rally about five cents on a 100bp rate cut.

He also said that longer-term two-year gilts probably have another 50 to 100 basis points to lose before peaking in the current interest rate cycle.

By Erik Kevin Franco, This email address is being protected from spam bots, you need Javascript enabled to view it , edited by Nancy Girgis, This email address is being protected from spam bots, you need Javascript enabled to view it

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