Hamish McRae: No cut yet but it's only a matter of time before the Bank lowers interest rates

If the Bank of England Monetary Policy Committee is wise it will be talking seriously about the timing of its next interest rate cut.

Cut? Yup. A few weeks ago the talk was about the timing of the next increase but now the game has flipped. Hardly anyone now expects a rise this cycle. While it is too early to expect a cut today, it is not too early to think about the possible sequence of events that will signal when the next cut is to come.

What has changed? There have been two big shifts, one global, the other domestic. A few words about each.

The global picture is that the incipient slowdown is upon us. There has been such a clutch of disappointing data from the eurozone, with Italy and the Netherlands in recession, that I will refrain from rubbing their noses in it by going through it yet again.

What is worth mentioning is that in the past week all three main lead indicators of manufacturing have weakened. The US ISM index has fallen from 53.3 to 51.4, the European PMI is down from 49.2 to 48.7 and the UK PMI from 49.5 to 47.3. Anything less than 50 implies a contraction of output. The economics team at JP Morgan notes also that Korea and Taiwan seem to be slowing and suggests that the Chinese economy may be weaker than generally perceived.

As far as the UK is concerned there are two questions. Does the economy need a rate cut? And can you justify it on inflation grounds?

You cannot quite say the economy needs it yet. The growth of retail sales, allowing for distortions resulting from the timing of Easter, has slowed to a crawl but it is not yet evident that it has gone into reverse. That fall in manufacturing expectations is as much about the global decline as any UK collapse of demand. The housing market has stalled in terms of prices but there seems to have been a modest pick-up in turnover since Easter.

But note the relationship shown in the first graph. The CSFB economists have spotted that the statistic that has had the closest relationship with changes in policy is the manufacturing PMI - purchasing managers' index. The line shows what has happened to the index since 1997, when the Bank took over control of interest rates. The bars show changes in interest rates, up or down. As you can see, when PMI heads south as it is now doing, it is not long before interest rates start to head down too. In very crude terms, that looks to me like a cut this autumn. CSFB, by the way, thinks that the country may be closer to a cut than it had previously thought, though for global rather than UK reasons.

Is there room for a cut? On paper there is no question about that. Inflation is just a touch below the benchmark of 2 per cent on the Consumer Price Index and the expectation in the last Inflation Report is for it to remain flat at around that level.

The inflation target is supposed to be symmetrical. The Bank is required to worry as much about an undershoot as an overshoot. Well, inflation had consistently undershot the target for most of the period when the Bank was pushing rates up, so it has demonstrated that it can take a relaxed view about that requirement. It was - quite rightly - more worried about the long-term effects of the housing boom than the official requirement on it.

Now it can, if it becomes equally worried about a collapse in global demand, allow some modest overshoot in inflation for a period. It can cut rates even if the case on paper for so doing is quite weak.

Actually there is very little pressure on prices to rise - remarkably little given the tightness of the labour market. The CPI has run at between 1.5 per cent and its present 1.9 per cent for the past three years but the intriguing thing is the extent to which this is a composite of stable or falling prices for goods and rising prices (or charges) for services. The second graph shows the pattern back to the beginning of 2001.

What seems to have been happening is that global goods prices have been held down by the advent of China on the world stage. Not all the goods we buy are sourced from China (though if you look at the labels in the shops it feels like it) but competition from China has had the effect of holding down prices of goods made elsewhere.

Meanwhile the price of services has risen more in line with rising wage costs. That graph does include public sector services, the cost of which has been shooting up, and the rise in private sector charges is somewhat lower. Strip out the public sector and other administered prices, and the service performance is rather better.

Conclusion? There is little or no inflationary rise in an early rate cut. Or put another way, the Bank would have perfectly respectable arguments to support a cut in rates if that were what the Monetary Policy Committee decided to do.

The international context is changing too. Whereas a couple of months ago the expectation was for the US Federal Reserve to make several more quarter-point increases in rates, now some wise observers, such as the Bank Credit Analyst team in Montreal, think there may be only one more rise this cycle.

Meanwhile in Europe we have the Germans openly pleading for the European Central Bank to cut rates by half a point to 1.5 per cent, a view endorsed by the chief economist at the OECD.

The ECB can argue that the fall in the euro in the past few days has in effect loosened policy enough and the decline is certainly very helpful to eurozone exporters. If the Northern League in Italy keeps up the pressure in calling for a return of the lira, then the euro is likely to fall even further. So, Northern Leaguers, you know your patriotic duty. But given the really quite dire situation in the eurozone I doubt that these efforts to talk down the euro will be sufficient and the ECB will indeed be forced into a cut before the end of the year.

So the global context for a cut could be compelling. It would certainly fit in with this context for the Bank to lead the next interest rate cycle by going first into the turn.

What should we be looking for, to tell us to expect a cut by October? First, there is that PMI number: two further falls would be a clear signal. Second, there is the UK housing market: actual falling prices through the summer (as opposed to stable prices) would be another.

Third, any modest decline in employment (or, though it is a lagging indicator, a significant rise in unemployment) would permit a fall because it would show reducing pressure in the labour market. Next, a significant rise in sterling: we really don't want that and it may well happen if the euro really bombs. And finally, a clear indication from the Fed that rates would not rise further, and/or of course a cut by the ECB.

The chances of enough of these happening before the autumn is out? My judgement is that it must be odds on. And you want a month for that first cut? OK, since you asked: October.