It is the first rate cut by the Bank of England (BOE) since March 2009 and comes six weeks after voters in the U.K. elected to leave the European Union (EU), which weakened the outlook for growth and triggered a sharp fall in the pound's exchange rate that is likely to push up short-term inflation above the BOE's 2 percent target as higher import prices are passed through to consumer prices.
But after the impact of the lower exchange rate on inflation dissipates, the BOE expects inflation to fall back down due to weak demand and said its stimulus measures were specifically aimed at reducing the spare capacity in the economy to ensure that inflation settles around its target.
Each element of the BOE's package of stimulus measures can be adjusted and if new economic data is consistent with the BOE's forecast, "a majority of members expects to support a further cut in Bank Rate to its effective lower bound at one of the MPC's forthcoming meetings during the course of the year," the central bank said, adding this lower bound was considered to be "close to, but a little above, zero."
"The decision to leave the European Union marks a regime change," BOE Governor Mark Carney said in his remarks to a press conference.
"In the coming years, the UK will redefine its opens to the movement of goods, services, people and capital," he said, adding that this adjustment may prove difficult but expressed confidence that the UK could handle it as it has one of the most flexible economies in the world, with its people "admitted the world over for their strength under adversity."
The rate cut and the TFS was approved by a unanimous vote by the BOE's 9-member Monetary Policy Committee (MPC). But only eight members supported the corporate bond schemed and six voted for further purchases of UK government bonds.
While Carney said the BOE's measures cannot fully offset such a large structural shock as leaving the UK, it can support the necessary adjustment during "a period of heightened uncertainty."
The BOE's rate cut and stimulus measures were widely expected by investors and financial markets and comes after the BOE last month stayed its hand while waiting for concrete data on how the economy was reacting to the uncertainty triggered by the June 23 vote to leave the EU.
The exchange rate of the pound has fallen around 9 percent since the EU referendum - known as Brexit - and while this will help UK exports, the BOE doesn't expect it to fully offset the drag from a substantial weakening of private domestic demand from higher unemployment and lower businesses investment during the period of uncertainty and lower real estate markets.
BOE staff have now updated their economic forecasts and slashed its outlook for economic growth in 2017 to 0.8 percent, based on the modal, from its previous inflation report in May of 2.3 percent. The outlook for 2016 growth was maintained at 2.0 percent while the 2018 forecast was cut to 1.8 percent from 2.3 percent.
Inflation in the third quarter of next year was seen rising to 1.9 percent from an unchanged 0.8 percent this year, but up from the previous projection of 1.5 percent. In the third quarter of 2018 consumer price inflation is seen rising to 2.4 percent, up from 2.1 percent, and then remaining at 2.4 percent in the third quarter of 2019.
The projections were based on market interest rates implying that the Bank Rate would by cut to 0.1 percent by the third quarter of next year and remaining at that level through the third quarter of 2018 before rising to 0.2 percent by the third quarter of 2019.
Carney described the BOE's measures as "timely" because the combination of a weaker outlook and lags in the transmission of monetary policy dictated the need for stimulus now.
The rate cut will immediately ease the financing conditions for households and firms as around half of mortgages have floating rate contracts and more than four-fifths of bank loans by firms are at floating rates.
However, given that rates are already very low, the BOE recognizes that its rate cut may not be fully passed on to households and firms, noting that in some cases borrowers in Europe have faced rising interest rates despite lower central bank rates.
To tackle that, the BOE is launching the Term Funding Scheme, which allows UK banks and building societies to borrow up to 100 billion pounds over the next year to reinforce its rate cut, reduce the effective lower bound of the Bank Rate to close to but a little above zero, charges a penalty if banks don't lend and covers all types of lending.
The new stimulus measures will be financed by the BOE electronically crediting banks' reserves held at it. By boosting its government bond purchases by 60 billion pounds, its total stock of such assets will rise to 435 billion.
Supporting the BOE's stimulus is a decision by the Financial Policy Committee to amend the leverage ratio for UK banks to exclude central bank reserves and an earlier decision to increase the availability of credit by up to 150 billion pounds by cutting the counter-cyclical buffer to zero.
The Bank of England issued the following statement:
"The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ending 3 August 2016, the MPC voted for a package of measures designed to provide additional support to growth and to achieve a sustainable return of inflation to the target. This package comprises: a 25 basis point cut in Bank Rate to 0.25%; a new Term Funding Scheme to reinforce the pass-through of the cut in Bank Rate; the purchase of up to £10 billion of UK corporate bonds; and an expansion of the asset purchase scheme for UK government bonds of £60 billion, taking the total stock of these asset purchases to £435 billion. The last three elements will be financed by the issuance of central bank reserves.
Following the United Kingdom’s vote to leave the European Union, the exchange rate has fallen and the outlook for growth in the short to medium term has weakened markedly. The fall in sterling is likely to push up on CPI inflation in the near term, hastening its return to the 2% target and probably causing it to rise above the target in the latter part of the MPC’s forecast period, before the exchange rate effect dissipates thereafter. In the real economy, although the weaker medium-term outlook for activity largely reflects a downward revision to the economy’s supply capacity, near-term weakness in demand is likely to open up a margin of spare capacity, including an eventual rise in unemployment. Consistent with this, recent surveys of business activity, confidence and optimism suggest that the United Kingdom is likely to see little growth in GDP in the second half of this year.
These developments present a trade-off for the MPC between delivering inflation at the target and stabilising activity around potential. The MPC’s remit requires it to explain how it has balanced that trade-off. Given the extent of the likely weakness in demand relative to supply, the MPC judges it appropriate to provide additional stimulus to the economy, thereby reducing the amount of spare capacity at the cost of a temporary period of above-target inflation. Not only will such action help to eliminate the degree of spare capacity over time, but because a persistent shortfall in aggregate demand would pull down on inflation in the medium term, it should also ensure that inflation does not fall back below the target beyond the forecast horizon. Thus, in tolerating a temporary period of above-target inflation, the Committee expects the eventual return of inflation to the target to be more sustainable.
The MPC’s choice of instruments is based on a consideration of their likely impact on the real economy and inflation. The MPC has examined closely the interaction between monetary policy and the financial sector, both with regard to ensuring the effective transmission of monetary policy to households and businesses, and with consideration for the financial stability consequences of its policy actions.
The cut in Bank Rate will lower borrowing costs for households and businesses. However, as interest rates are close to zero, it is likely to be difficult for some banks and building societies to reduce deposit rates much further, which in turn might limit their ability to cut their lending rates. In order to mitigate this, the MPC is launching a Term Funding Scheme (TFS) that will provide funding for banks at interest rates close to Bank Rate. This monetary policy action should help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that households and firms benefit from the MPC’s actions. In addition, the TFS provides participants with a cost effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets.
The expansion of the Bank of England’s asset purchase programme for UK government bonds will impart monetary stimulus by lowering the yields on securities that are used to determine the cost of borrowing for households and businesses. It is also likely to trigger portfolio rebalancing into riskier assets by current holders of government bonds, further enhancing the supply of credit to the broader economy.
Purchases of corporate bonds could provide somewhat more stimulus than the same amount of gilt purchases. In particular, given that corporate bonds are higher-yielding instruments than government bonds, investors selling corporate debt to the Bank could be more likely to invest the money received in other corporate assets than those selling gilts. In addition, by increasing demand in secondary markets, purchases by the Bank could reduce liquidity premia; and such purchases could stimulate issuance in sterling corporate bond markets.
As set out in the August Inflation Report, conditional on this package of measures, the MPC expects that by the three-year forecast horizon unemployment will have begun to fall back and that much of the economy’s spare capacity will have been re-absorbed, while inflation will be a little above the 2% target. In those projections the cumulative growth in output is still around 2½% less at the end of the forecast period than in the MPC’s May projections. Much of this reflects a downward revision to potential supply that monetary policy cannot offset. However, monetary policy can provide support as the economy adjusts. Had it not taken the action announced today, the MPC judges it likely that output would be lower, unemployment higher and slack greater throughout the forecast period, jeopardising a sustainable return of inflation to the target.
This package contains a number of mutually reinforcing elements, all of which have scope for further action. The MPC can act further along each of the dimensions of the package by lowering Bank Rate, by expanding the TFS to reinforce further the monetary transmission mechanism, and by expanding the scale or variety of asset purchases. If the incoming data prove broadly consistent with the August Inflation Report forecast, a majority of members expect to support a further cut in Bank Rate to its effective lower bound at one of the MPC’s forthcoming meetings during the course of the year. The MPC currently judges this bound to be close to, but a little above, zero.
All members of the Committee agreed that policy stimulus was warranted at this time, and that Bank Rate should be reduced to 0.25% and be supported by a TFS. Eight members supported the introduction of a corporate bond scheme, and six members supported further purchases of UK government bonds.
These measures have been taken against a backdrop of other supportive actions taken by the Bank of England recently. The FPC has reduced the countercyclical capital buffer to support the provision of credit and has announced that it will exclude central bank reserves from the exposure measure in the current UK leverage ratio framework. This latter measure will enhance the effectiveness of the TFS and asset purchases by minimising the potential countervailing effects of regulatory requirements on monetary policy operations. The Bank has previously announced that it will continue to offer indexed long-term repo operations on a weekly basis until the end of September 2016 as a precautionary step to provide additional flexibility in the Bank’s provision of liquidity insurance. The PRA will also smooth the transition to Solvency II for insurers. "
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