The pound has fallen to its weakest level in 12 years after the Bank of England signalled that it is no longer prepared to raise interest rates.
Sterling dipped sharply against both the dollar and the euro after the Bank used its quarterly Inflation Report to slash its economic growth forecasts and predicted that inflation will dip back towards its 2pc target over the next two years.
The pound dropped by 1.8pc on its trade-weighted index, which measures it against a basket of other currencies, to 90.8 points – the lowest level since December 1996. In one of its biggest ever falls against the dollar, it dropped 3.6 cents to $1.8651. It also weakened significantly against the euro, dropping more than 1p to 79.71p.
It followed Bank Governor Mervyn King’s warning that the next year will be “painful” as the economy stagnates or shrinks and inflation rises to around 5pc.
Although this indicates that the Bank will have no room for interest rate cuts in the immediate future, the Inflation Report also suggested that higher borrowing costs were not necessary to keep prices under control.
The news sent expectations for interest rates plunging. Two-year interest rate swap rates dropped by almost 19 basis points to 5.3385pc – the lowest level since May. By late afternoon, the money markets were pricing in a 50:50 chance of rates being cut by November.
Economists said that although there was a growing chance that the Bank will cut before the end of the year, it would be difficult to do so until inflation has passed its peak.
In recent months, the pound has fallen sharply against the euro and, more recently, the dollar as investors react to the fact that the UK economy’s prospects have deteriorated sharply.
The Inflation Report said: “[Markets] believe that much of the fall in [sterling] reflects a, possibly temporary, increase in the sterling risk premium.”
The report warned that Britons must prepare themselves for a “difficult year” as their disposable income shrinks, and as house prices continue to fall. For the first time since gaining independence, the Bank forecast that the economy will shrink at the turn of the year, with Mr King acknowledging that recession is now quite likely.
The Bank’s forecast indicates that the economy will grow by only around 1.5pc this year and below 1pc next year – well below the 1.75pc and 2.25pc minimum levels envisaged by the Chancellor in the Budget earlier this year.
However, Mr King said that in one important area – namely banks’ cashflow – the financial crisis had now passed its worst.
“It is true to say that in the area of liquidity we probably have moved to a better situation,” he said. “You can see from the measures that central banks have taken around the world that liquidity issues have certainly improved.
“Attention is now turning away from liquidity and more towards questions of funding and viability of an institution’s business plan.”
However, in an apparent shot across the bows of the Government, which is reportedly considering providing a guarantee for certain high-quality mortgages, he said: “We don’t guarantee lending to other forms of borrowing. We don’t guarantee lending to manufacturing borrowing. There is no reason why in the long run you need to have any guarantee of lending to the mortgage market.
“It would be very dangerous to move to a situation where the Government saw its major role as guaranteeing lending. Why should the taxpayer take on the risk for borrowing by individual borrowers, some of whom are risky? It’s the lenders who should take the risk and assess for themselves the riskiness of that lending.”
By Edmund Conway and Angela Monaghan
Last Updated: 11:18pm BST 13/08/2008