City stands by for further round of interest rate cuts

THE CITY is expecting further cuts in interest rates after the Chancellor reversed his cautious policy on Friday with a 1 point cut designed to head off a slump in confidence.

Analysts said the motive for the drop to 8 per cent base rates was political panic, following the announcement of 30,000 redundancies at British Coal, a fall in manufacturing output, and a rise in the male unemployment rate to a post-war high.

The City has become increasingly worried that the Government has lost the initiative on economic policy and is hostage to events. Friday's move - although more aggressive than many analysts expected - failed to change that impression.

Kevin Gardiner, economist at Warburg Securities, said that immediately after leaving the exchange rate mechanism, the Government had wanted to make clear that it was not prepared to take risks with inflation. 'But it has tried that and been overtaken by events for the second time in a month. Its U-turn is now likely to become a little more complete.'

Mr Gardiner expects interest rates to be at 7 per cent by the end of the year. 'The Chancellor has given a very public signal that he is prepared to take serious risks with medium and long- term inflation. Long-term inflation expectations will take a serious knock on this move,' he said.

Though sterling was fully 6 pfennigs below its DM2.51 level on Monday, when the Chancellor told the Commons' Treasury Committee that he would take the exchange rate into account in his anti-inflation policy, Mr Lamont stressed that Friday's rate cut was 'fully consistent with the Government's inflation objectives'.

The Treasury issued an unprecedented detailed statement of the rationale behind the move, in which the Chancellor listed indicators that suggested inflation would not rise. It pointed to falling house prices, slow growth in the amount of money circulating in the economy and surveys showing subdued pressure on prices.

Most economists agree that the immediate inflationary impact of lower interest rates and the falling pound will be limited because the economy is so depressed - the effects will show up later on. 'In 12 to 18 months we are going to have higher inflationary pressure,' said Ruth Lea, economist at Mitsubishi Bank. She added that the Chancellor would probably only be deterred from cutting rates if the pound fell to DM2.35.

Friday's rate cut had a limited effect on the pound, which fell less than 2 pfennigs against the mark to DM2.4470. David Cocker, economist at Chemical Bank, said the pound would have fallen anyway and would be buoyed by measures that were seen as boosting hopes of a recovery.

'But the Government will not be able to cut rates soon from here,' said Mr Cocker. He added that the Chancellor had given a clear signal that Britain would not be returning to the European exchange rate mechanism 'for some time to come'.

Some City economists argued that the Chancellor needed to go further. 'This was a step in the right direction. But interest rates need to be cut to around 6 per cent and it is not implausible that could happen by early next year,' said Neil MacKinnon of Citibank.

He pointed to experience in the US, where the dollar had fallen and interest rates had been cut to 3 per cent, yet the economy was still not recovering strongly. In both the US and Britain, the effect of interest rate reductions have been limited, because spending is being deterred by large burdens of personal and business debt.

Friday's cut in base rates was roundly cheered by housing analysts, who held out the hope that the market would start to improve before too long. Gary Marsh of the Halifax, Britain's largest mortgage lender, said it was 'a move in the right direction'.

People 'should not be dismissive about its potential impact,' he added. 'So long as this is seen as sustainable, it will help confidence. Of course, rising unemployment means there is a lot of fear, and that will continue to be a big problem.'

The Halifax's house price index recorded its biggest fall in September, dropping 3.1 per cent in a month and bringing the annual decline to more than 7.5 per cent.

Though the society attributes the sharpness of the decline to special factors such as the ending of the stamp duty suspension in August, it continues to call for further base rate cuts combined with direct incentives, such as an increase in mortgage interest relief directed particularly at first-time buyers.