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UK: Bank to boost money supply and cut rates

  The Bank of England looks set to cut interest rates to close to zero on Thursday and announce it will start raising the money supply to drag Britain out of recession as it runs out of scope to lower rates any further.

Policymakers reckon that buying government bonds and commercial securities from banks will encourage them to lend to households and businesses, stimulating growth, and they have asked for Treasury approval to create new money to do that.

Chancellor Alistair Darling has already given his blessing to the scheme, known as quantitative easing, and the Treasury will publish an exchange of letters between Bank Governor Mervyn King and Darling later this morning setting out a limit on how much new money the Bank can create.

Analysts reckon that limit will be around £100 billion ($142 billion). “These are very drastic measures to try and resolve the situation,” said Hann-Ju Ho, senior economist at Lloyds TSB Corporate Markets. “Because of the credit crisis, the amount of money needs to be boosted in addition to the government efforts aimed at making the money flow around the system quicker,” he added.

The Bank’s Monetary Policy Committee will probably also cut interest rates by half a percentage point to a record low of 0.5% when their meeting ends at 12:00 a.m. to provide an additional boost to confidence. The majority of 62 economists polled by Reuters last week expected the MPC to cut rates by half a percentage point from their current record low of 1%. However, a significant minority saw a risk of a smaller cut or no reduction at all.

Indeed, the MPC is worried that cutting rates further will hamper economic recovery by putting more pressure on banks’ margins and make them restrict lending even more. Still, uncertainty about the effectiveness of QE and an unwillingness to surprise financial markets may persuade the MPC to reduce borrowing costs again anyway.

“The call for a 50 basis point cut rests on the idea that, after a month’s reflection and with markets anticipating a 50bp cut, the MPC will decide the concerns on profitability are not enough to outweigh the argument to move,” said Malcolm Barr, economist at JP Morgan.

NEW TOOLS NEEDED

Japan experimented with quantitative easing earlier this decade with limited success. But with interest rates around the world close to zero and the world’s major economies in recession or near it, central banks are having to explore other options.

Britain fell into recession for the first time in nearly 2 decades in 2008 and the economy shrank at its sharpest rate in nearly 30 years at the end of the year.

More worryingly, the Bank forecasts inflation will fall well below its 2% target, and policymakers have even mentioned the risk of deflation, a broad-based drop in the level of prices which could trigger a dangerous downward spiral in demand.

The Bank says a shortage of money circulating through the economy poses the biggest obstacle to any recovery, but because it cannot be addressed by cutting interest rates, the only other option is to raise the money supply by buying assets.

The central bank has already made a cautious start in buying commercial paper from banks under its Asset Purchase Facility, but this is financed by issuing Treasury bills. And policymakers will probably want to proceed cautiously with QE, so their first purchases of assets are likely to be small to give them a chance to gauge the effectiveness of the strategy. (Reuters)