Bank of England Cuts Rates to 1.5%

Lowest Level in Bank's 315-Year History

JOELLEN PERRY and ALISTAIR MACDONALD / Wall Street Journal 8jan2009

Amid signs of deepening recession across Europe, the Bank of England lowered its key rate Thursday by a half percentage-point to 1.5%, the lowest level in the bank's 315-year history.

In Britain, where rates Thursday fell to their lowest since the central bank's founding in 1694, intense debate is now focused on how officials will handle monetary policy as interest rates approach zero. The U.S. Federal Reserve, faced with the prospect of a deep and prolonged recession, has lowered its target interest rate to near zero from 5.25% in little more than a year. U.S. policy makers have also launched roughly a dozen new lending and asset-purchase programs designed to support financial markets.

Dismal European economic data published on Thursday, including rising unemployment, falling consumer and business confidence, and a sharp drop in German exports, now puts more pressure on the European Central Bank. Questions are now increasing about why the European Central Bank, which meets next week, is moving more cautiously to cut is key rate. The ECB, which makes monetary policy for the 16-nation euro currency zone, has cut its key rate to 2.5% from 4.25% in October, but policy makers have signaled some reluctance to keep cutting aggressively.

European shares recouped some losses on Thursday after the Bank of England's rate decision, having retreated earlier in the day on worries about the economy. The Dow Jones Stoxx index of Europe's 600 largest companies is down 0.76%, or 1.59 points, at 208.72.

Having outperformed its economic peers for over a decade, the U.K. economy is expected to be one of the biggest casualties of the credit crisis. British gross domestic product contracted by 0.6% in the third quarter of 2008, and recent economic data suggests the picture has deteriorated dramatically since. House prices fell by some 16% last year, unemployment is at its highest in nearly a decade and manufacturing activity contracted for the eighth straight month in December.

The Bank of England's rate cuts to date have brought little relief. The central bank has cut its key rate from 5% since last October. But Bank of England data last week showed lending fell sharply in the final months of 2008, intensifying worries that the government's £500 billion ($725 billion) bank-rescue plan is failing to get money flowing.

There were signs Thursday that the trend could be changing. Lloyds TSB Group PLC, one of the U.K. banks that received government cash, said in a statement that it would pass on the full 0.5 percentage point cut to many of its customers, including small businesses – a sector that has complained about a lack of credit.

As interest rates near zero, the Bank of England and U.K. Treasury are also examining contingency plans for so-called quantitative easing, officials say. This could include printing money to buy up commercial debt and so free up banks to lend more. But government officials were keen to stress on Thursday that the U.K. is not close to doing this yet.

The UK government is also mulling a range of options to kick-start lending in Britain, including extending government guarantees on loans to business and guaranteeing bonds backed by assets such as car loans and mortgages, people familiar with the matter say.

Abysmal data across the euro-zone, a $12.2 trillion economy second in size only to the U.S., is putting pressure on ECB policy makers to speed up the pace of their rate-cut campaign. European statistics agency Eurostat confirmed Thursday the bloc's economy shrank by 0.2% in the third quarter, following a 0.2% contraction in the second quarter. Two consecutive quarters of contraction is one definition of recession.

Most economists believe a far steeper fourth-quarter contraction is in store, a prediction supported by a welter of dismal data Thursday. Euro-zone business and consumer confidence fell to their lowest levels on record in December as firms noted rapidly shrinking order books and consumers registered mounting fears of joblessness, according to a European Commission survey.

Euro-zone unemployment, meanwhile, rose to 7.8% in November from 7.7% in October, its highest since December 2006. The sharp falloff in global and domestic demand is likely to bring the rate higher this year.

The outlook in Germany, Europe's largest economy, is darkening rapidly. Slumping demand for cars and other manufacturing mainstays pushed German exports to a 10.6% monthly fall in November, according to the Federal Statistics Office. The slide is the sharpest since German reunification in 1990. German manufacturing orders also slipped sharply, falling 6.0% in November from October, according to the Ministry of Economics. That's just under the 6.3% fall in October, but far more than the 2% drop analysts polled by Dow Jones Newswires had forecast.

ECB policy makers acknowledge the deepening economic malaise. "It's clear that we have had a significant deterioration of the real economy," ECB president Jean-Claude Trichet told Institutional Investor magazine in an interview published Wednesday. Markets expect the central bank to deliver a half-percentage point rate cut, to 2%, at its meeting next week. Many private-sector economists forecast the policy rate will hit 1% by mid-year.

But some policy makers, including the bank's chief economist Juergen Stark, have expressed reluctance to keep cutting rates quickly. Banks' ongoing reluctance to lend to one another is keeping the rates on those loans, which are an important benchmark for some consumer and business loans across the euro-zone, high. That dilutes the economic impact of central-bank cuts.

ECB policy makers also fret that by bringing their key rate too close to zero, the central bank could lose its power to influence the euro-zone economy. "Do we have a feeling there is a limit to the decrease in rates?," said Mr. Trichet in mid-December. "At this stage, certainly yes."

source: 8jan2009