By Sumeet Desai and Matt Falloon
LONDON, Jan 20 (Reuters) - The British economy will likely shrink markedly in the first half of 2009 and policymakers need to think about using more than just interest rates to stimulate demand, Bank of England Governor Mervyn King said on Tuesday.
In his first major speech of the year, King also said the fall in sterling -- it hit a 7-1/2 year low against the dollar earlier -- would help support the economy this year, as would lower oil prices and substantial fiscal and monetary easing.
"Nevertheless, the problems in the financial sector mean that 2009 will be a difficult year for all of us. A pronounced contraction in spending and output is underway," he said, according to the text of a speech being delivered in Nottingham.
"With Bank Rate already at its lowest level in the Bank's history, it is sensible for the Monetary Policy Committee to prepare for the possibility -- and I stress we are not there yet -- that it may need to move beyond the conventional instrument of Bank Rate and consider a range of unconventional measures."
King and his MPC colleagues cut the official Bank Rate to 1.5 percent this month and most analysts expect a further 50 basis point reduction next month, taking borrowing costs close to zero and paving the way for so-called quantitative easing.
Such unconventional measures, King explained, would take the form of the central bank buying a range of financial assets, thereby boosting the money supply and increasing available credit to companies.
In the literature, this consists of buying government securities to boost the money supply. Provided banks don't just hoard the new money as happened in Japan earlier in the decade, the extra cash in the system can boost spending, he said.
"The effectiveness of this approach is likely to be enhanced by the clear commitment by the MPC to take the measures necessary to meet the inflation target in the medium-term," he said.
GOVERNMENT GREEN LIGHT
King also noted there are "unconventional unconventional measures" that could be used when credit markets are not working, which would not only help unjam frozen markets but also raise the money supply at the same time.
The British government gave the BoE the authority to do just that on Monday as part of its second bank rescue package.
The new BoE Asset Purchase Scheme is a 50 billion pound fund financed by the issue of Treasury bills to buy high-quality assets in order to get credit flowing again.
The government said it would also form the basis for the BoE to use in order to manage the economy if it so chose, where the BoE raised the monetary base to find its purchases.
"At some point, the Monetary Policy Committee might wish to adopt these unconventional measures as an instrument of monetary policy," King said.
The asset buying scheme to help impaired markets would go ahead in a matter of weeks, not months, he said, and the BoE was actively looking at corporate bonds and commercial paper.
"There is a fine dividing line between helping to oil the wheels in markets which are temporarily impaired, and artificially supporting markets in which there is no underlying demand," he said.
"Therefore, the Bank will need to be satisfied that there is a genuine private demand for an asset in normal conditions before it would be eligible for the asset purchase facility."
King said that while things looked bleak now, very significant actions will eventually stimulate a recovery -- interest rates have fallen from 5 percent to 1.5 percent and the MPC has a range of options to stimulate the economy more.
"Since the summer, the exchange rate has fallen by almost 20 percent; and oil prices have fallen by around two-thirds, both of which will boost demand," he said.
Fiscal policy has also been eased and the banking system is getting huge support with restructuring its balance sheet.
"Time is a great healer, even of banks," he said.
For a Factbox on how the BoE might buy assets, please click on [ID:nLK138921].