Rate cut on knife edge

After a nail-biter in December, January's interest rate decision is shaping up to be just as close, according to economics consultant, Capital Economics. It makes the point that the Bank of England's Monetary Policy Committee (MPC) seems pretty certain that rates need to fall significantly further and will be keen not to fall 'behind the curve'. But inflation risks mean that it might still prefer to take a gradual approach to loosening policy.

Capital believes it marginally more likely the MPC waits until February. However, the fast-moving economic and financial situation means that the balance could easily tip towards an immediate cut, as occurred just before December's meeting. Either way, it thinks rates will eventually fall as low as 4%.

It isn't often that the MPC signals as clearly as it has done recently that a significant change in interest rates is required. November's Inflation Report indicated that rates might eventually have to fall to 5%. The subsequent deterioration in financial market conditions and housing-related news meant that at December's MPC meeting, the Committee judged the downside risks to activity and inflation had increased further. The MPC therefore concluded in December that a substantial loosening in policy might be needed.

Capital argues the Committee probably now believes that rates need to fall below 5%. Accordingly, it may be starting to worry that, even after December's rate cut, it has fallen behind the curve and there is little point in delaying before cutting rates again. After all, the MPC noted in December's minutes that the restrictive level of interest rates puts it in a good position to act pre-emptively without losing credibility on the inflation front.

Admittedly, if the Committee were that worried, it would arguably have cut by 50 basis points in December. Instead, it put forward the case that a large reduction in Bank Rate now would increase the upside risk to inflation - a concern that might equally apply to consecutive rate cuts. That said, the MPC might think that two small cuts are less likely to boost inflation expectations than one big cut. What's more, some of its inflation concerns might have eased over the past month.