Preview - Bank of England prepares for the worst

December 8th 2011: Preview - Bank of England prepares for the worst

There has been a feverish pace of activity in Threadneedle Street as Bank of England officials anxiously scan Euro-zone developments amid increasing fear that a second credit crunch and recession are heading rapidly for the UK. The Monetary Policy Meeting this week will also be an anxious affair as the economic outlook darkens. The most likely outcome is that policy will be left on hold at Thursday’s meeting, but that the bank will make all necessary preparations for emergency action including a huge expansion in quantitative easing if there is a Euro-zone worst-case scenario which threatens to swamp the UK.

Sterling will gain some immediate support if policy is left on hold today, but weakening growth, together with the threat of economic and political isolation, leave Sterling at the mercy of shifting sentiment and confidence is liable to unravel rapidly. The UK government has already been forced to downgrade its growth forecasts and increase its borrowing by a projected GBP100bn over the next five years. With the UK debt position already perilous even before the latest downgrades, a further downturn would cause huge damage and the Bank of England will need to consider what further support can be provided.

Recent comments from members have suggested strongly that the central bank is prepared to take further action. Indeed, the general tone of commentary indicates that they expect further measures will be required. The key variables which need to be addressed are timing and the aggressiveness of any further easing.

There will be concerns that Libor rates have been increasing with 3-month Sterling rates consistently trading above the 1.0% level, more than double the official interest rate level of 0.50%. The bank could consider cutting rates to 0.25% in an attempt to stop retail interest rates rising, although the primary difficulty is the availability of credit not the cost. There is also the potential for further quantitative easing in the form of bond purchases and this is likely to be the preferred route.

As far as timing is concerned, the bank wants to wait until the current bond-purchase programme is competed in February. There is certainly a high risk that Euro-zone events will force a re-think and if the Euro-zone implodes over the next few days then there will be the need for urgent action.

There are extremely high uncertainties surrounding the Euro-zone outcome and the MPC will not want to second-guess developments, especially with the extremely important Summit due to take place on Friday.

Follow breaking developments on Twitter - @Investicafx

For a full list of market previews follow this link Market Previews

FXToday - Free Forex signals