The British pound fell to a 22-month low yesterday (Wednesday), after the Bank of England (BOE) offered a gloomy outlook for the U.K. economy and the chance of an interest rate cut increased.

The pound fell to $1.8656 yesterday – its lowest level since October 2006 – from 1.8968 the day prior. The British currency has fallen 5.4% against the dollar so far this year, and 7.6% against the dollar since the end of July. The pound is down 7.5% against the euro this year.

The decline has been prompted by a perceived shift in BOE policy, as many analysts see the central bank as shifting its focus from inflation to declining growth. 

“Inflation is yesterday’s story and UK growth is falling to pieces,” David Bloom of HSBC Bank (ADR: HBC) told the Financial Times. “The pound is going to get absolutely thrashed.”

The BOE has held its rates steady since April in an effort to subdue inflation, which hit a decade-high 4.4% in July. But the central bank struck an ominous chord when it lowered its growth forecast for the first quarter of 2009 and said inflation would be below 2% by 2010.

The BOE said the economy would grow 0.1% year-over-year in the first quarter of 2009, compared to its previous growth forecast of 1%.

Analysts at both BNP Paribas SA (OTC: BNPQY) and JPMorgan Chase & Co. (JPM) have moved up their predictions for an interest rate cut, and said the Bank of England could cut its benchmark rate as early as November of this year.

A sharp rise in unemployment, which rose for a sixth straight month in June, has emerged as the predominant threat to the British economy. The jobless rate hit 2.7% in June, up from 2.6% the month prior. Unemployment, as measured by International Labor Organization standards could rise by 25% to more than 2 million, Bloomberg News reported.  ILO-based unemployment jumped to 5.4% in the second quarter, the highest level in close to a year.

The International Monetary Fund last week predicted U.K. economic growth would grow by 1.4% in 2008 and 1.1% in 2009, down from its previous estimate of 1.8% for 2008 and 1.7% for 2009.

“It may still be summer but there is a feeling of chill in economic air,” said BOE Governor Mervyn King. “The British economy is going through a difficult and painful adjustment.”

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In an effort to restore liquidity to the U.K. financial markets, the Bank of England (BOE) yesterday (Monday) announced a $100 billion (50 billion pounds) rescue plan.

The plan, similar to the U.S. Federal Reserve’s lending initiative, will allow U.K. banks to swap illiquid mortgage-backed assets for government bonds. The BOE hopes the plan will encourage banks to begin interbank lending again, which in turn should loosen up commercial lending as well.

The plan will "unfreeze the situation we’ve got at the moment," Chancellor of the Exchequer Alistair Darling said in an interview with the BBC, Bloomberg News reported. "What the Bank of England will do is, in effect, lend the banks that money. In the meantime, the Bank of England will take a security."

Analysts believe the plan will help in the short-term, however, due to restrictions in the plan and the high cost of punitive terms, demand for funds could be muted.

"We believe the proposed asset swap scheme will help ameliorate pressures within funding markets," Bank of America Corp. (BAC) analyst Matt Sharratt told BusinessWeek. "Still, it is unlikely to be a silver bullet."

The BOE will honor the asset swaps for one year, the option to renew for an additional three years. Only pre-existing assets can be used as collateral for the swaps.

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The announcement put downward pressure on the pound sterling, which was down over 0.6% at the close in New York.

"If banks use this facility, liquidity spreads will ultimately come down due the additional liquidity in the system, but there will be no immediate relief for the stressed mortgage market, explaining the negative reaction of sterling," PNB Paribas analysts said, the AFP reported.

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The Bank of England (BOE) cut its interest rate 25 basis points to 5.0% yesterday (Thursday) while the European Central Bank (ECB) held its rate steady at 4.0%.

The move by the BOE’s Monetary Policy Committee (MPC) was the third quarter point rate reduction since December as the United Kingdom faces many of the same problems currently plaguing the U.S. economy including a housing slump.

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U.K. inflation is currently at 2.5%, above the BOE’s desired 2% target rate, but the central bank feels the current risks to economic growth outweigh inflationary concerns.

"Credit conditions have tightened and the availability of credit appears to be worsening," the MPC said in its policy statement.

The statement did not foreshadow another rate cut when the MPC next meets in May.

"With today’s move arguably only providing a partial offset to the recent tightening of credit conditions, RBC Capital Markets suspects that the pressure is on for a follow up cut in somewhat short order and, indeed, sees some significant risk of a further 25-basis-point reduction in May, " Richard McGuire, economist and fixed-income strategist at RBC Capital Markets, told MarketWatch.

Meanwhile, the ECB, led by President Jean- Claude Trichet elected to maintain its current interest rate due to inflation pressures.

"We are experiencing a rather protracted period of temporarily high annual rates of inflation," Bloomberg News reported Trichet said at a press conference in Frankfurt yesterday after the ECB vote. While financial-market tension may have "a broader than currently expected impact on the real economy," ensuring price stability is "very serious for us," he said.

European inflation is currently at a 16-year high. And while Europe’s growth is expected to slow, the IMF forecast it would expand at a 1.2% rate, twice the 0.6% that is expected for the United States.

The U.S. Federal Reserve has cut its rate by 3% to 2.25% since September.

"The world is caught between ice and fire – slower growth and inflation," Dominique Strauss-Kahn, managing director of the IMF, said yesterday. "Inflation is back."

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The Bank of England’s nine-member Monetary Policy Committee cut its benchmark interest rate by a quarter point to 5.25% yesterday (Thursday), in an attempt to fight off the country’s slowing consumer spending and precipitously falling housing prices.

"In the United Kingdom, credit conditions for households and businesses are tightening. Consumer spending growth appears to have eased. Although the substantial fall in the sterling exchange rate is likely to promote re-balancing of total demand, output growth has moderated to around its historical average rate and business surveys suggest that further slowing is in prospect," the bank said in a statement. "These developments pose downside risks to the outlook for inflation."

Like the U.S. Federal Reserve, the Bank of England expressed concern of fueling inflation, which at 2.1% in December is slightly above its target of 2%. However, the bank expects inflation to cool later in the year.

"The committee needs to balance the risk that a sharp slowing in activity pulls inflation below the target in the medium term, against the risk that elevated inflation pressures keep inflation above target," the statement said.

The rate cut follows suit with the Bank of Canada, which also cut its rate by a quarter point to 4% after the U.S. Federal Reserve reduced its benchmark rate three-quarters of a point in an emergency session Jan. 21.

The Federal Reserve then cut its benchmark rate another half-point on Jan. 30 to the current rate of 3.25%. 

ECB Stays Put, Then Wavers

While interest rates are dropping in England and Canada, the European Central Bank left its benchmark rate at 4% and its President, Jean-Claude Trichet, threatened to raise rates if data showed the U.S. slowdown will affect Europe.

"There was no call for increase of rates or decrease of rates," Trichet told reporters, USA Today reported. "That does not mean that we did not discuss very thoroughly all the elements that are making up the situation."

Hours later, he backpedaled. 

"Uncertainty about the prospects for economic growth is unusually high," Trichet said later, Bloomberg reported.

The ECB’s situation is a little more complex than that of the United Kingdom because it’s making decisions for each of the 15 economies tied together by the euro.

The developing economies in Eastern Europe have seen their inflation climb last year. Meanwhile, Western European stalwarts such as Germany and France have seen their largest banks -Deutsche Bank AG (DB) and Societe General (SCGLY) – take on massive write-downs from subprime-stained assets.

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• USA Today:
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• Bloomberg: 
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