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Bank tipped to cut rates as deflation risk looms
Hugo Duncan25.11.08
The City was today betting on another deep cut in interest rates as Britain faced up to a dangerous bout of deflation.
Economists said the cut in VAT from 17.5% to 15% would push the Consumer Prices Index rate of inflation below the 0.5% forecast by the Chancellor in the Pre-Budget Report.
A period of deflation looks a real possibility as the VAT holiday and tumbling food and oil prices drag inflation rapidly down from the current rate of 4.5%. The Bank of England is expected to cut rates from 3% to 2.5% next week following this month's dramatic 1.5 percentage point cut from 4.5% to 3%. The monetary policy committee is under pressure to do all it can to prevent deflation while the tax cuts and spending plans in the PBR are unlikely to be enough to stave off a nasty recession.
George Buckley of Deutsche Bank said: "The decision to use cuts in the VAT rate as the main channel of the fiscal stimulus means that the risk of deflation is now higher than it was.
"In the event that a large portion of the VAT cut is passed on to consumers, we would not be surprised to see CPI slip into a brief period of deflation before the end of next year. While the PBR should provide a helpful boost to the economy at a time when it is desperately needed, there is no guarantee that this will be enough.
"Indeed, we continue to expect the Bank of England to cut rates at its meeting next week. We suspect the MPC will opt for a 50 basis points easing this month."
Richard McGuire of RBC Capital Markets said the Bank will be wary of aggressive rate cuts as it waits to see what impact the fiscal stimulus will have on consumer spending.
"That said, with the VAT change making it almost certain CPI turns negative next year, there is a strong case for aggressive easing so as to head off possible expectations of deflation," he said.
Reader views (1)
To link a reduction in VAT as contributing to deflation is absolutely wrong. It may cause a dip in inflation but all VAT proceeds go to the government and do not affect company profits.
Genuine deflation is escalating price falls because nobody is buying your products, which cause wages to reduce, which makes people unable to buy your products etc etc. We are not there yet but the fear is.
Deflation increases the weight of indebtedness because debts do not reduce as the power to repay them reduces, unlike inflation which reduces the burden of debt.
Deflation benefits savers and not borrowers. As it is borrowers and lenders who have got us into this sorry mess, by irresponsible lending and not to forget, irresponsible borrowing, might this not be called poetic justice.
However, deflation hurts us all by punishing G Browns imprudent and irresponsible borrowing by reducing the purchasing power of sterling. This will, inevitably lead to further falls in the pound's value and ultimately higher long term interest rates to attract foreign and institutional gilt buyers.
What can the government do then, apart from the recent borrowing slurge and stimulus plans? Print money and inflate their way out of the problem. Look at Argentina who have done exactly that to reduce foreign debt obligations. Hasn't done their economy much good though.
Soon as that happens the game's up, if you have any savings left at that moment buy some gold and batten down the hatches!
- Chris Simmonds, Herne Bay, Kent, UK
