Rate cut leaves markets expecting rise within a year

The unexpected fall in base rates yesterday sent the pound lower and left the financial markets betting that rates will have to rise again within the next 12 months.

On a day that brought additional evidence that the economy is picking up, City reaction to Kenneth Clarke's surprise was mixed. Many analysts argued that it was a political move and likely to have been opposed by Eddie George, Governor of the Bank of England.

''The Bank of England warned that this is just the stage of the cycle when mixed signals on the economy mean policy-makers make mistakes. Mr Clarke should not have cut interest rates,'' said James Barty, UK economist at the investment bank Deutsche Morgan Grenfell.

David Walton at Goldman Sachs said the Governor probably accepted the case for a cut in the short term but would have warned that base rates might have to go up again later. ''It does leave a nagging doubt that the politics is coming into play,'' he said.

Geoffrey Dicks, an economist at NatWest Markets, noting that Mr Clarke had promised to raise rates later if necessary, said: ''We are ready to hold the Chancellor to his word.''

Speaking about its Inflation Report last month, Mervyn King, the Bank's chief economist, said he saw no need for the extra insurance against short- term economic slowdown that another base rate reduction would bring. The report predicted a small risk that inflation would be above its 2.5 per cent target in 1998.

However, recent figures showing continuing recession in manufacturing industry, combined with the strength of the pound, allowed Mr Clarke to make out a good case for reducing the cost of borrowing. ''I am satisfied that this modest further cut in interest rates is fully consistent with my target of inflation below 2.5 per cent,'' he said yesterday.

The Chancellor's panel of ''wise persons'' lent some support to this view. In a special report on the ''output gap'' coincidentally published yesterday morning, they concluded that the economy had room to grow at a faster rate than normal for three to five years without causing a rise in underlying inflation.

Even so, some of the panel's members had doubts about the latest reduction. Martin Weale of the National Institute of Economic and Social Research said: ''If there is an economic justification for yesterday's rate cut, it is the rise in the exchange rate. But will the Chancellor put rates up again if necessary? Probably not.''

Sterling's index against a range of other currencies has gained 5 per cent this year. According to the Treasury's rule of thumb, this is equivalent in effect to an increase of more than 1 per cent in base rates. The higher pound will help reduce already weak inflationary pressure.

Roger Bootle, chief economist at HSBC Markets, predicted that base rates will have to fall even further to offset the impact of the strong currency on manufacturing.

Simon Briscoe at the Japanese bank Nikko agreed: ''There can be little doubt after this move that if the economy is weak in the next couple of months the Chancellor will be prepared to cut rates.''

However, yesterday's economic statistics provided more evidence for a healthy pace of economic recovery. Last month saw the eighth successive annual increase in the volume of retail sales, according to the CBI's survey of the distributive trades.

The pace of growth was a little slower than April, and less than expected. However, retailers' optimism about future sales returned to its highest since December 1988, despite the fact that their recent expectations have been consistently disappointed.

Alastair Eperon, chairman of the CBI's distributive trades panel, welcomed the emergence of a ''feel-better mood" among consumers.

Estate agents Black Horse brought news of a property shortage as thousands of potential buyers re-entered the housing arena. It said 43 per cent of its offices had reported a shortage of three- or four-bedroom semi- detached houses.

David Wood, managing director, said: "Buyers are obviously judging now as the right time to re-enter the market, or buy for the first time.''

According to the Halifax's figures, house prices have climbed at an annualised rate of 12 per cent so far this year.

Separate figures from the Society of Motor Manufacturers and Traders (SMMT) yesterday showed that new car registrations last month were 8.5 per cent higher than a year earlier. The SMMT was particularly encouraged by a sharp rise in retail purchases.

Venture capitalists 3i reported that optimism among small and medium- sized companies had risen for the second quarter running, especially those not involved in manufacturing.

In addition, the number of companies going into receivership rose between April and May but was a third lower than a year earlier, according to accountancy firm Deloitte and Touche. There was a particularly significant drop in the South-east.

Treasury officials and ministers hold their annual Dorneywood meeting this weekend to kick off discussions of this year's Budget strategy. The Chancellor is due to give his Mansion House speech, traditionally on monetary policy, next Wednesday.

Sterling lost more than a pfennig in value against the mark yesterday, closing at DM2.3580. The short sterling futures market soared, but continued to point to base rates back near 7 per cent a year from now.

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