UK paves way for world-wide fall in interest rates

Interest rates were last night set to fall around the world. Following Britain's quarter-point fall to 6.5 per cent, Germany is expected to shave rates today and New York markets are already pricing in a rate cut.

Wall Street surged late yesterday, sending the Dow Jones Industrial Average index through 5,200 to record levels.

In the UK, Kenneth Clarke's decision to cut rates brought to an abrupt end the shortest and shallowest interest rate cycle in recent history.

The decision to cut rates by only a quarter point disappointed industry and commerce, but signalled further cuts to come in the new year.

Britain's markets showed muted enthusiasm: gilts ended fractionally stronger, and sterling strengthened from 82.8 to 83 on the trade-weighted exchange rate index.

In the short sterling contract used by the City to bet on interest rate changes, there was a further hardening in expectations that further rate cuts were on the way. By the end of the day, it was implying base rates of 6 per cent by June.

City economists were divided about the move. Steven Bell, chief economist at Deutsche Morgan Grenfell, said the cut was the right decision because conducting monetary policy was like peering into the fog - "you're less likely to fall into traps if you take small steps."

However, Roger Bootle, chief economist at HSBC Markets, said the decision to cut by a "niggardly" quarter of a point was both timid and dangerous, given the ebbing away of confidence in the real economy. There was an equally sharp clash of views over whether the united front presented by Mr Clarke and Eddie George over the decision had restored the credibility of the present monetary arrangements in which the Bank has been given more influence in the shaping of interest rate policy. The extended stand- off over the summer between the Bank's call for higher rates and the Chancellor's refusal to sanction it had threatened to bring the new system into disrepute.

Mr Bell said that the cut had more credibility because Mr George had recommended it. However, Mr Bootle voiced his suspicion that "there was probably a negotiation before the meeting with Mr George opposed to any cut and Clarke wanting a half per cent, with the quarter point cut emerging as a compromise".

Despite this mixed reception to the cut in rates, one thing is clear: it marks an extraordinary turnaround in expectations. The day after the Bank of England lifted rates last December from 5.75 to 6.25 per cent, the City consensus was that rates had much further to go in 1995 - to 8 per cent by June and almost 9 per cent by December. With the economy growing at 4 per cent in 1994 and Britain's sorry track record in curbing inflation, a sustained tightening in monetary policy seemed inevitable.

In the event, rates peaked after one further rise to 6.75 per cent in February. Yesterday's cut in rates acknowledged the reality that growth has slowed much more than had been expected - and that inflation has not accelerated out of control as had widely been feared.

In between came the epic struggle between Mr George and Mr Clarke over the call by the Governor of the Bank of England for a further hike in rates in May. Apparently as much to the surprise of his own Treasury officials as to the Bank, Mr Clarke unexpectedly overrode Mr George's recommendations that a further jump in rates was needed to offset the inflationary effects of the 5 per cent fall in the pound in the first half of the year.

The Chancellor undoubtedly emerged the winner in this first trial of strength under the new monetary arrangements that had given the Bank more influence in the shaping of interest rate policy. But he came out on top principally because the economic indicators went his way rather than the Governor's.

Growth, which had initially been thought to be running at 0.8 per cent in the first quarter of the year, equivalent to an annual rate above trend, was revised down to 0.6 per cent. Still more worrying, the expansion of the non-oil economy in the third quarter of 1995 slowed still further to just 0.3 per cent, well under half the underlying rate of growth the Treasury now thinks the economy can sustain.

Back in May, the Bank's central forecast for inflation targeted by the Government - retail prices excluding mortgage interest payments - was that it would peak at almost 4 per cent early next year and that it would be at 3 per cent at the begining of 1997. In November, the Bank still cautioned that inflation would be just over the Government's target of 2.5 per cent or less in two years.

"Our view has changed," Mr George told a press conference after the decision to cut rates. New information since the November report pointed to an improved outlook for inflation, such that the Bank now thought the Government would probably hit its inflation target.

Today's figures for inflation will provide an early test of the credibility of the decision.