Bank of England set to cut rates to 5%

Policymakers in England are set to deliver their third interest rate cut in five months tomorrow to help borrowers under increasing pressure from the credit squeeze.

In the first three months of 2008, homeowners struggling to find scarcer and more expensive mortgage deals have been at the sharp end of the pain felt by major banks following last summer’s crunch.

Despite lingering inflation concerns, it is this drying up of credit available to households – and the knock-on effect on the economy as spending falters - which is likely to see the Bank of England’s Monetary Policy Committee (MPC) cut rates by 0.25% to 5%.

The nine-strong committee is keen to see the UK economy ease the pace of its soaraway growth in recent years, but the Bank’s latest credit conditions survey, published last week, raised fears of a harder than anticipated landing.

Philip Shaw, chief economist at Investec Securities, said: “The survey presented a bleak picture of reduced credit availability to households and corporates, with expectations of a further squeeze on funds over the next three months.

“The credit squeeze continues to pose significant downside risks to the economy and this has been accompanied by comments from the Bank expressing increasing concern.”

While mortgage demand among people who are moving home is set to fall, the survey predicted increased demand from those remortgaging, as more borrowers come to the end of fixed-rate and discount deals.

Despite lenders such as internet and telephone bank First Direct closing its doors to new customers and the Co-operative Bank pulling all of its two-year deals, the demand is set to intensify over the next three months, the Bank predicts.

But the number of mortgage products available has fallen by 40% during the past month alone, with fewer than 5,000 different deals currently on offer.

Consumer confidence meanwhile is at a low ebb, with the Nationwide building society’s index of sentiment falling for the sixth month in a row during March to the lowest point since its launch in May 2004.

And this week, the latest housing market survey from Halifax revealed a shock 2.5% fall in average house prices last month – the biggest month-on-month fall since 1992 and the second largest ever.

In March, Bank Governor Mervyn King gave public voice to the phrase “credit crunch” for the first time and told MPs he was predisposed to cut rates further as more expensive mortgage deals from lenders cancelled out previous rate reductions in February and December.

The Governor said the UK’s modest slowdown was far from the slump gathering pace in the US, where the free-fall in the housing market triggered the losses on sub-prime mortgage investments felt by banks across the world.

But he did warn that the standard of living among UK households would rise at a much slower rate as soaring food costs, rising petrol prices and higher energy bills since the start of the year also squeezed consumers.

While the MPC is expected to have discussed the possibility of a more drastic half-point cut – which would be the first such move lower since November 2001 in the aftermath of the 9/11 attacks – these inflation risks are likely to restrict the pace of rate cuts.

The committee is charged at keeping the official cost of living at 2%, but it is currently above target at 2.5%. Last week the Bank’s head of markets, Paul Tucker, said the MPC would cut rates “gradually” and was prepared to tolerate increased slack in the UK economy to deal with the heightened inflation risks.

While there have been cries of pain from the financial sector, manufacturers also saw better than expected growth in February, helped by a weaker pound.

Services firms – accounting for around three-quarters of the UK’s GDP - maintained growth despite easing activity, but gave another inflation warning with the CIPS/NTC Purchasing Managers’ Index showing cost inflation at the highest level since its study began 12 years ago.

Most experts predict at least one more cut after tomorrow, although how far borrowing costs eventually fall will be linked to recovering conditions in credit markets.

The Bank is pumping £15bn into money markets next week, which has begun to ease the rate at which banks lend to each other for three months. The so-called Libor rate reached its highest point this year late last month, peaking above 6% – more than 0.75% above the official interest rate.

Mr Shaw predicts interest rates could fall to 4% or lower if the crunch shows no sign of easing.

He added: “The critical determinant will be whether there are signs of normalisation in credit markets. If so, there may not be any more downside to rates.

“However there are mounting risks that credit conditions will remain dysfunctional for some time to come.”