Bank of England May Cut Rates as U.K. Economy Slumps

By Jennifer Ryan and Svenja O'Donnell

Aug. 26 (Bloomberg) -- Bank of England policy makers may cut U.K. interest rates this year to protect the economy from recession even as inflation breaches the government target by the widest margin ever, according to a survey of economists.

Half of economists in a Bloomberg News survey on Aug. 22 forecast a rate reduction before the end of 2008, up from 1-in-4 in a poll on Aug. 8. The bank has held its benchmark rate at 5 percent since April as the inflation rate climbed to 4.4 percent in July, more than double the 2 percent target.

Policy makers, who have been weighing the threat of inflation against risks of a recession, may tip toward the need to prop up growth after the economy unexpectedly stalled in the second quarter. Governor Mervyn King said the U.K. faces a ``painful adjustment'' as expansion slows to tame prices.

``They will have to get off that fence and start cutting,'' said Grant Lewis, an economist at Daiwa Securities SMBC Europe in London and a former U.K. Treasury official. ``After inflation peaks in September, the bank's dilemma will get easier, and they will end up having to be pretty aggressive.'' He forecasts a rate cut in November.

The U.K.'s longest stretch of economic growth in more than a century ended as business investment deteriorated the most since 1985 and household spending contracted for the first time in three years, the government statistics office said on Aug. 22. Economists had expected a 0.1 percent increase.

Survey Results

Twelve of 24 economists polled by Bloomberg News last week say the key rate will drop to at least 4.75 percent by the end of the year. That compares with seven of 28 economists when the survey was conducted at the beginning of the month.

Minutes published Aug. 21 covering the August decision for no change in the key rate showed a three-way split in the nine-member panel, the second such division in as many months. Timothy Besley preferred an increase to tame price growth, while David Blanchflower wanted a cut to guard against inflation slowing too far below the target.

Economists brought forward their expectations for a rate cut after the bank published quarterly forecasts on Aug. 13 showing inflation will dip below the 2 percent goal in two years if interest rates remain unchanged.

``The British economy is going through a difficult and painful adjustment,'' King said as he delivered the forecasts. He said output will be ``broadly flat,'' meaning ``there is a possibility of a quarter or two of negative growth.''

Deputy Governor Charles Bean said in an interview with the British Broadcasting Corporation published yesterday that the credit crisis ``will drag on for some considerable time.''

Dropping Pound

Recent reports have sparked a 6.7 percent drop in the pound this month against the dollar, the worst monthly decline since October 1992, when it lost 12 percent.

Some economists are sticking to forecasts for no change in rates this year. They argue that cutting rates while inflation quickens may tell wage bargainers and companies setting prices that the bank isn't focused on meeting its inflation mandate.

King said Aug. 13 a ``reasonable person'' would expect price gains ``to remain high for a while,'' and that the consumer-price index would peak at around 5 percent. Scottish & Southern Energy Plc and E.ON AG's British unit said last week they would charge customers more for power and gas to offset rising wholesale costs.

``A cut seems unwise,'' said Jeavon Lolay, an economist at Lloyds TSB Bank Plc in London. ``Until we're sure that this hump in inflation is out of the way and it's not going to lead to second-round effects, rates should remain on hold.'' He forecasts no change in the benchmark through the end of 2009.

Housing Market

A recession, along with the worst housing-market downturn in more than a quarter of a century and rising joblessness, may be enough to squeeze household consumption and keep price increases from sticking.

Bank of America Corp. economist Matthew Sharratt cut his forecast for U.K. rates last week. He now expects reductions starting this year and the benchmark rate to fall to 3.5 percent by the end of next year, compared with a previous call for rates at 4 percent by the third quarter next year.

``The risk of a mild recession is around 30 percent,'' Sharratt wrote in a research note on Aug. 22. ``The Bank of England will have to come to the rescue in coming months despite concerns over the near-term inflation profile.''

To contact the reporters on this story: Jennifer Ryan in London at Jryan13@bloomberg.netSvenja O'Donnell in London at sodonnell@bloomberg.net