Little Room for Manoeuvre; Economist with Global Insight Howard Archer Assesses the Issues Facing the Bank of England's Monetary Policy Committee on the Eve of Its Latest Decision on Interest Rates

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Byline: Howard Archer

TOMORROW'S interest rate decision from the Bank of England is becoming a closer call by the day.

Recent weak data and survey evidence relating to consumer confidence, retail sales, the housing market and manufacturing activity heighten concerns that the UK economic downturn is deepening and add to the pressure on the Bank of England to quickly cut interest rates again despite current elevated inflation levels and risks.

We still modestly lean towards the view that the next cut in interest rates, from 5.00% to 4.75%, will come in June. Nevertheless, further markedly weaker data and surveys could well trigger an interest rate cut tomorrow (the April purchasing managers survey for the services sector could be particularly influential).

Further out, we anticipate that interest rates will fall to 3.75% by early2009as extended below-trend growth increasingly undermines companies' pricing power and limits wage growth. We see UK GDP growth being limited to 1.6% in 2008 and 1.4%in 2009 With signs growing that the UK economy is slowing markedly in the face of major headwinds and credit conditions remaining very tight, the Bank of England is under serious pressure to cut interest rates for a second successive month at the conclusion of its May policy meeting.

At the same time though, inflation pressures remain elevated and are currently showing few signs of easing, thereby continuing to severely limit the Bank of England's room for manoeuvre.

The difficult situation facing the MPC as it tries to juggle slowing UK growth and serious downside risks to the outlook with current elevated and still rising inflation was reflected in the three-way split in the MPC's voting in April.

Timothy Besley and Andrew Sentance voted for interest rates to remain unchanged at 5.25%, while David Blanch flower was in favour of a larger interest rate cut from 5.25% to 4.75%. The other six MPC members judged that a weakening growth outlook meant that the downside risks to inflation over the medium term had increased relative to the upside risks, thereby warranting the 25 basis points interest rate cut to 5.00% which was duly enacted The minutes of the April meeting also highlighted the MPC's ongoing very difficult position as it faces serious downside risks to the growth outlook but also current elevated inflation pressures.

The committee is particularly concerned that current elevated inflation levels - primarily resulting from higher utility and food prices, as well as a markedly weaker pound-could lift inflation expectations and there by have significant second round effects through affecting the behaviour of price and wage setters. …