The Bank of England’s stunning decision comes amid questions over the recent judgment of its rate setters.
The 1.5 per cent cut – on top of October’s 0.5 per cent drop – marks a dramatic shift for the Monetary Policy Committee (MPC) as it seeks to regain the initiative against the backdrop of an all but inevitable recession.
But as recently as August, some MPC members were voting to actually hike rates as worries over inflation and higher wage demands dominated thinking.
Inflation is now yesterday’s problem even though it stands at 5.2 per cent, more than double the Bank’s official target.
The MPC’s gloomy statement alongside its dramatic cut instead confirms that the Bank has turned full circle in the space of two months and is now locked in a fully-fledged fight against deflation, as prices tumble in a sharp recession.
“The downside risk was that a sharp slowdown in the economy, associated with weak real income growth and the tightening in the supply of credit, pulled inflation materially below the target,” it said.
The committee’s lone doomsayer, David Blanchflower, has been calling for cuts for the past year and stands vindicated by events.
The US-based professor expects unemployment to top two million by Christmas as the UK plunges into recession.
In a thinly veiled attack on his colleagues last week, he said: “With hindsight, monetary policy has not been sufficiently forward looking.
“It is not sufficient to consider the data month-by-month until it emerges that the UK is in recession. I believe the trend has been apparent for some time.”
The latest and severest outbreak of the crisis sparked by the collapse of Lehman Brothers has shocked the MPC into action.
The European Central Bank also cut rates by 0.5 per cent, bringing rates to 3.25 per cent, slightly less drastic than the MPC’s move.
But the European Commission yesterday suggested the UK could need stiffer medicine, singling out the nation’s “budget deficit and debt spiral” as it estimated unemployment rates rising to 7.1 per cent next year – higher than the EU-wide unemployment increase.
Just 10 days before the banking crisis erupted – at September’s meeting when rates were held at five per cent – the MPC was saying any cut “would signal some slackening in the MPC’s commitment” to meet the two per cent inflation target.
Mr Blanchflower was the sole dissenter, calling for a half point cut and presciently arguing a slowdown “might be amplified by financial institutions” responses to increased financial fragility”.
IHS Global Insight economist Howard Archer said: “A year ago Blanchflower was seen as the maverick, but now he has turned into a guru.”
But Mr Archer added that it would be unfair to blame the rest of the MPC for not following the professor’s lead and said the committee had done a good job in 11 years of independence.
“They could not have foreseen what happened. The heightened financial turmoil we have seen since mid-September changed the situation quite markedly.
“It was only in July that oil was $147 a barrel. You could see what the Bank of England was concerned about.”
Investec economist David Page said: “Few monetary authorities have presided over a period as tumultuous as this, so it is hard to judge how they should have moved.”
The crisis afflicting banks desperate to rebuild their balance sheets also means lenders are more reluctant to pass on lower borrowing costs, blunting the weapons in the MPC’s arsenal.
“The credit crunch itself has emasculated monetary policy – the methods of transmission are deadened,” he added.
The current turbulence facing rate setters also demonstrates the wider limits of monetary policy because it is “an impossible job” to accurately forecast the economy and inflation two years ahead.
A look at the Bank’s inflation report years ago illustrates this. By this view, growth is at a healthy 2.7 per cent, with inflation steady at the two per cent target, in contrast to a steep 0.5 per cent plunge in output and inflation roaring away at 5.2 per cent.
Now fresh from writing letters to the Chancellor to explain rampant inflation, Bank governor Mervyn King could be penning fresh missives in a year’s time to account for sharp deflation as the MPC struggles to meet its mandate of price stability.
Mr Blanchflower, who has been right so far, is concerned that inflation could fall below one per cent or even turn negative.
“The objective of the MPC is to bring things back to normal,” he said. But it faces a long and difficult fight.