Expect the unexpected

How does monetary policy work?

In its answer to that question the Bank of England's website says "While there is no practical upper limit to the level of Bank Rate, there is a level below which it cannot be reduced – known as the effective lower bound (ELB)." Fair enough, but what is the ELB? 

A paper by the BoE's Richard Harrison in 2012 observed that "In principle, the ELB may be lower than zero…But in practice, the ELB may be positive for a number of reasons". Governor Mark Carney told parliament's Treasury Committee six months ago that, while "we could cut interest rates towards zero" he had "no intention and no interest" in negative rates. (His opposite numbers in Zürich, Stockholm, Tokyo and Frankfurt do not share that view: they all have negative rates of one sort or another.)

It is conceivable that changing circumstances could cause Dr Carney to change his mind on the subject but not before he and his team "engage in additional asset purchases, including a variety of assets".  Their first move, though, would be to move Bank Rate closer to zero and that is what is expected today.

Two five or not two five?

There is near-unanimity among analysts that the Monetary Policy Committee will decide today to cut Bank Rate by 25 basis points to 0.25%. There is an outside chance that it will decide to buy more government bonds after a three-year pause. Yet sterling is stronger.

Having suffered on Monday from a weak UK manufacturing sector purchasing managers' index the pound has strengthened through two even weaker readings from the construction and services sectors. Over the last two days sterling's only loss is the half-cent it conceded to the Australian dollar. It is a curious result: one of the two top performers has already had an interest rate cut this week and the other is probably about to get one.

A reasonable explanation for sterling's pickup is that the world and her husband were - and some say still are - excessively short of the pound: The last two day's rally is simply the result of them covering some of those short positions.

Reaction guaranteed

It is fairly safe to say that the Bank of England announcement will provoke a reaction from investors that will affect the pound. However, it is far from certain what that reaction will be.

If the response to the Reserve Bank of Australia rate cut on Tuesday is anything to go by, a quarter-percentage-point cut would send the pound temporarily lower. It would then recover all the lost ground because the rate reduction has been thoroughly discounted by the market.

But this is sterling we are talking about. Predictability is not its strong suit at the best of times and right now investors are hell-bent on chasing it through Brexitland. A further complication is the bank's quarterly Inflation Report, which will coincide with the monetary policy announcement. Be careful out there!