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CPI inflation rose to 2.5 per cent in February.

Inflation expected to rise further

The Committee said it expects inflation to rise further this year, reflecting the continuing impact of higher energy and food prices, as well as the recent depreciation of sterling on import costs. Such pressures are already evident in producer input costs and pricing intentions.

Even if commodity prices remain at their current high levels, inflation should fall back. To ensure that inflation meets the 2 per cent target in the medium term, however, the Committee said it needs to balance two risks.

On the upside, above-target inflation this year could raise inflation expectations so that, in the absence of some margin of spare capacity, inflation would remain above the target.

On the downside, the disruption in financial markets could lead to a slowdown in the economy that was sufficiently sharp to pull inflation below the target.

Domestic inflationary pressures

In the Committee’s judgement, the balance of these risks to the inflation outlook in the medium term justified a cut in Bank Rate this month.

Credit conditions have tightened and the availability of credit appears to be worsening. While the recent depreciation in sterling will support net exports, the prospects for output growth abroad have deteriorated.

In the United Kingdom, business surveys suggest that growth has begun to moderate and that a margin of spare capacity will emerge during this year. This should help to keep domestic inflationary pressures in check in the medium term.

Against that background, the Committee judged that a reduction in Bank Rate of 0.25 percentage points to 5.0 per cent was necessary to meet the 2 per cent target for CPI inflation in the medium term.

Dysfunctional market conditions 

Michael Coogan, director general of the Council of Mortgage Lenders, called the rate cut good news for those borrowers with mortgages tracking the Bank base rate, but warned that in these "dysfunctional" market conditions, the base rate is not in itself a good guide to the cost or availability of funds to lenders.

Coogan said that to improve the market in which lenders are operating and restore consumer confidence, the Bank needs to coordinate successive base rate cuts with further injections of more widely available liquidity. 

"We would like to see another base rate cut next month partnered with more liquidity auctions, of higher amounts, over longer terms, and available to a wider range of institutions. This coordinated approach would help to show the authorities are serious about tackling the market problems,"  Coogan added.

Inflation could breach limit

Edward Menashy, Chief Economist at Charles Stanley, said that Central Banks are well aware of the benefits of low inflation.

He pointed out that it was the low inflation climate of the mid 1980's and 1990's that enabled interest rates to fall, allowing bonds and equities to rise.

"In turn low interest rates reduced the cost of capital and encouraged investment, employment and wealth creation.  There is no central banker worth his salt who would not want to achieve low inflation," he said.

Menashy added that inflation flowing through this pipeline in the UK could cause the Consumer Price Index (CPI) to breach the limit of 3.1 per cent. 

That would require a letter of explanation to be written by the Governor of the Bank of England to the Chancellor of the Exchequer explaining why the target was breached.

"Yet, no less a person than the Prime Minister stated yesterday that with UK inflation being so low the MPC could lower interest rates. In the circumstances, exceeding the inflation target would be looked upon as no more serious than a traffic offence,” Menashy concluded.

Inflation left free to rise

Trevor Williams, chief economist Lloyds TSB Corporate Markets, said that the decision must have been one of the toughest the Monetary Policy Committee (MPC) had faced for a while.

"It will be fascinating to see just how close the vote was, when the minutes are published later this month. If the MPC had kept rates on hold, it would have left the economy exposed to a slowdown. By cutting rates, however, it has left inflation free to rise even further beyond its target," he added.

Williams believes that it was probably the stream of economic data published in recent days that tipped in the end the balance in favour of a cut.

The Bank of England's own report on credit conditions was anything but upbeat, predicting that credit is set to become both scarcer and costlier.