Credit Quake Persists Ahead of UK Interest Rate Cut of 1%?

By: Nadeem_Walayat

The Bank of England is expected to follow last weeks U.S. interest rate cut of 0.5% by cutting UK interest rates at Thursdays MPC meeting, speculation is growing that in the face of the economic meltdown of the economy that is falling off the edge of a cliff, that the Bank will take the unprecedented action of cutting interest rates by a whole 1%. The problem here is that as I have observed and commented on these past few years is that the Bank of England's MPC is incompetent , having repeatedly failed in all respects, which is especially apparent in its primary objective of pegging UK inflation at CPI 2% and between the boundaries of 1% and 3%, therefore will the MPC be able to make the leap and cut interest rates by a whole 1% as the economy demands ? , read on...

The existing Market Oracle forecast is UK interest rate forecast to be cut from 5% to 3.25% by September 2009. However since the forecast was made, the Labour Government has significantly eroded the Bank of England's control over interest rates so that urgent action can be taken to prevent the recession from turning into an economic depression, this therefore increases the chances of a rate cut of far more than 0.5%, possibly even 1% at this Thursdays MPC meeting, as the targeting of inflation has now been effectively abandoned.

LIBOR Credit Quake Persists

The credit quake in the wake of Lehman's Bankruptcy continues to persist as observed by the Sterling LIBOR spread to the base interest rate. Despite all of the government actions to date of increasing tax payers liability by £500 billion to get the money markets to unfreeze and the banks lending again, the rate spread suggests that there has been little movement in the money markets. On the contrary it increasingly seems that the part nationalised banks are using tax payers money for mergers and acquisition purposes rather than lending.

What this effectively means is that the impact of interest rate cuts on the economy is subdued which implies that whilst UK interest rates stand at 4.5%, the impact on the economy is if interest rates were at 5.5%. Therefore a 0.5% cut to 4% would imply an economic rate of 5%, this reinforces the possibility of a rate cut of 1% to 3.5% would have the impact of bringing the rate to the economy down to 4.6%. This suggests that interest rates should be cut far more deeply than 'economic theory' that the academics in the ivory towers work with suggests i.e. to reach an economic rate of 3.5% we would need to see a UK interest rate of as low as 2%.

However, the question now is who is in charge of UK monetary policy ? For if it is the Bank of England Monetary Policy Committee then were are doomed to too little too late action as history suggests, then rate cuts will occur inline with the Market Oracle forecast towards 3.25% by September 2009.

However, if now Gordon Brown is in charge via his Darling mouth piece then we can expect a 1% cut in UK interest rates this Thursday. It will be interesting to see exactly who is in charge for a 1% cut will mean that the monthly MPC meetings are now a facade and we need to look elsewhere to determine what the UK's interest rate policy is than the uttering's from the mouths of MPC members. A cut of 0.75% will imply that there is a tug of war going on amidst much ambiguity, with the government not having made up its mind that it now wants total responsibility over interest rates. A cut of 0.5% means, well, we are doomed to a deep long recession, whilst the BOE MPC members sip tea and munch on digestives as they discuss the weather and the theories of monetary policy with little evidence of ever having actually participated in the money markets.

The Implications of Deep Interest Rate Cuts

Whilst people are quick to rejoice at the news of deep interest rate cuts to bolster the economy, however there is a price to pay as I voiced over 6 months ago that would occur following the Bank of England being forced to cut interest rates regardless of the inflation rate, and that price is in the CRASH of the British Pound from 2.10 to 1.55 or 26%! For there is no such thing as a free lunch, the crash in sterling will result in higher inflation beyond the current period of deflation i.e. the PERFECT STORM that we have been heading for these past 12 months, and now accelerating into. The perfect storm of asset price deflation coupled with currency devaluation inflation equals stagflation for several years, therefore this recession will be followed by subdued economic activity for many years.

Technically the British Pound is extremely oversold and it should rally back to above £/$1.70, however it is in full crash mode which was evident during the slice through support at £/$1.70 down to £/$152.80, therefore sterling may continue slicing through multi-year support levels all the way towards the armageddon hyper-inflationary support level of £/$1.37 despite the current extreme oversold state. This is extremely inflationary in terms of consumer prices, but deflationary in terms of real-terms asset prices. More on this in my forthcoming analysis and forecasts for UK inflation, GDP and of course the much in demand UK house prices following the crash of 2008 . Subscribe to our always free newsletter to get the scheduled analysis in your inbox on the day of publication.

By Nadeem Walayat
http://www.marketoracle.co.uk

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Nadeem Walayat has over 20 years experience of trading derivatives, portfolio management and analysing the financial markets, including one of few who both anticipated and Beat the 1987 Crash. Nadeem is the Editor of The Market Oracle, a FREE Daily Financial Markets Analysis & Forecasting online publication. We present in-depth analysis from over 150 experienced analysts on a range of views of the probable direction of the financial markets. Thus enabling our readers to arrive at an informed opinion on future market direction. http://www.marketoracle.co.uk

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