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UPDATE: Bank Of England Keeps Interest Rates On Hold At 5.75%

By Simon Kennedy

LONDON (Dow Jones) -- The Bank of England on Thursday kept its key interest rate unchanged at 5.75% as it continues to gauge the impact of the recent credit market turmoil and a sharp drop in inflation.

The decision was widely expected following five rate hikes since August last year and came a day after the central bank moved to reduce overnight borrowing costs by increasing the level of reserves commercial banks can hold with it.

In an unprecedented statement accompanying the decision, the central bank said it's too soon to tell how the disruption in financial markets will impair the availability of credit to companies and households.

The bank, which has previously only made a statement when rates are changed, said it "is monitoring closely the evolution of both credit spreads and the quantities of credit extended, alongside all other data relevant to the outlook for inflation."

Until recently, most economists in the U.K. were predicting interest rates would rise to 6% later in the year as economic data remained robust.

But many are now suggesting the current tightening cycle has peaked as credit market worries have slashed liquidity and driven up the interest rates banks charge each other to borrow money.

Inflation has also fallen back more sharply than expected, dropping to 1.9% in July. That was the first time inflation had been below the government's long-term target of 2% in more than a year.

In its statement the Bank of England acknowledged the drop in inflation, saying it could remain at or slightly below the 2% target for the next few months and added there are "tentative signs" of a slowdown in consumer spending.

But it also balanced those comments with a warning that pricing pressures remain somewhat elevated.

"The recent solid pace of output growth has been sustained and the margin of spare capacity appears limited," the bank said.

The main FTSE 100 indexextended losses after the announcement to trade down 0.5% at 6,238.70.

Sterling also turned lower, losing 0.1% against the greenback to change hands at $2.0185.

Ian McCafferty, chief economic adviser at the Confederation of British Industry, praised the decision to hold rates steady. He said the sharp fall in inflation has taken some of the force out of any argument for another hike and the economy now needs a long period of stability.

"The economy is at an important juncture. The growing signs of moderating activity and the uncertainty about the impact of the squeeze in money markets have left the bank with some difficult issues to ponder," he said in a statement.

Central banks take action

At its previous meeting in August, members of the bank's Monetary Policy Committee voted unanimously to hold rates. The meeting's minutes also noted that most members emphasized they had no firm view on whether rates would need to rise again.

Since that meeting, the credit market turmoil has worsened, prompting other central banks to inject billions of dollars of liquidity into the money markets.

The European Central Bank acted again Thursday by allocating around $57 billion in a one-day tender. The ECB also left its main interest rate unchanged at 4% on Thursday.

The Bank of England held back from taking any direct action on credit market worries until Wednesday, when it announced commercial banks could increase their reserves by 6% to 17.63 billion pounds and added it would make up to another 4.4 billion pounds available next week if overnight interest rates remain high.

However, it refused to act on longer-term interbank interest rates, saying these had risen because banks weren't willing to lend money, not because of a lack of central bank liquidity.

Amit Kara, an economist at UBS, said the bank's action to increase reserves doesn't rule out another rate hike if it believes there are still medium-term inflationary pressures.

"We still believe the MPC will consider one more rate hike, but this only if the turmoil in the financial markets subsides," Kara said in a note to clients before the latest rate decision.

"If, instead, the turmoil in the financial markets persists, there will likely be a material impact on the wider economy. In that case, the MPC will keep rates on hold in the near term and in our view even consider a rate cut next year," Kara added.

Economists at Lloyds TSB are predicting that rates have peaked at 5.75%, though recent data on the U.K.'s dominant services sector, which showed a surprise pick-up in activity in August, has kept alive the risk of a further hike.

Other data have been mixed, with a fall in wage inflation and the latest data on house prices showing price inflation in August had remained under 1% for the fifth consecutive month.

(END) Dow Jones Newswires

September 06, 2007 09:54 ET (13:54 GMT)


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