Clamour grows for interest-rate cut

News Analysis: Pay, inflation and the economy are slowing - but the MPC is unlikely to act just yet

THE BANK of England tomorrow begins its monthly two-day interest- rate setting meeting against a background of global financial turmoil and a slowing domestic economy. Calls for a rate cut grow louder with each day, and it is no longer only union leaders and industry bosses arguing the case for easier interest-rate policy.

Many City economists - several of whom were forecasting further rate rises just a few months ago - now believe the first interest-rate cut could come before year-end, although few believe the Bank will cut this week. And although there may be some debate about timing, the consensus is clear - the next move in rates will be down, not up. Base rates, according to the City, have peaked at 7.5 per cent.

"We've been forecasting a cut in the fourth quarter for some time, although it might be premature to expect it this month," said Marian Bell of Royal Bank of Scotland. "If I were on the MPC [the Bank of England's rate-setting Monetary Policy Committee] I'd certainly be starting to watch for the need for a cut."

Mark Wall at Deutsche Bank agreed the next move would be down, although he was more cautious about the timing. He said: "I do not see the MPC cutting rates this year, although there are huge uncertainties about the global economy."

According to the latest Merrill Lynch/Gallup survey, UK fund managers also see rate cuts ahead - 98 per cent expect the next move to be down, and none of the fund managers surveyed believed that rates would be higher one year from now.

The growing body of evidence suggesting that the domestic economy is slowing is one key factor behind the marked shift in City opinion.

Over the past month both the growth in average earnings and the inflation rate have fallen back, and there has been a raft of gloomy business surveys. Yesterday Pricewaterhouse-Coopers cut its forecast for 1999 UK GDP growth by 0.5 points to 1 per cent and argued that engineering, construction and textiles were particularly vulnerable to the downturn.

More evidence of the slowdown will come from the British Retail Consortium today. The BRC says August was another disappointing month for retail sales, with the value of sales increasing by just 1.5 per cent on a like- for-like basis compared with a year earlier. While September's year-on- year growth rate is likely to be more positive - partly because sales last September were depressed by the death of Diana, Princess of Wales - the underlying trend is still firmly downward, according to the BRC.

Bridget Rosewell, the BRC's chief economic adviser, said: "The latest results strengthen our view that consumers are cautious about their spending and that retail sales growth is generally weakening. Global economic factors do not suggest an early upturn."

But definite evidence of a weakening domestic economy is, on its own, unlikely to be sufficient to persuade the Bank to cut rates just yet, say the experts. The underlying inflation rate may have fallen, but it is still above the 2.5 per cent target. The rate of earnings growth may have fallen back, but it is still above the 4.5 per cent level the Bank considers incompatible with the inflation target. Many in the City believe unemployment needs to rise further before the Bank will feel comfortable cutting rates.

Richard Iley at ABN Amro said: "Until there is a sharp rise in unemployment, both pay pressures and the spectre of wage-push inflation will persist." Jonathan Loynes at HSBC Securities agreed: "It is not yet clear that the domestic economy has slowed as far as the hawks on the MPC would like," he said.

The recent fall in sterling, which yesterday shed over 2 pfennigs to close at DM2.8795, could also mean that rates stay higher for longer. Although few believe a weak pound would tip the balance in favour of another rate hike in the current environment, many think it could delay a cut.

"If the pound falls to the low DM2.80s any time soon it will strengthen the resolve of the Bank to keep rates on hold," said Mark Wall of Deutsche Bank.

However, although the domestic situation on its own may not be sufficient to persuade the Bank to cut rates, a new factor has come into play over the past two weeks - the turmoil in the global financial markets. A few days ago Alan Greenspan, the chairman of the US Federal Reserve, hinted that the Fed was considering an easier interest-rate policy amid concerns about the impact of the continuing emerging market turmoil on the global economy.

Indeed, in the wake of the 1987 crash the Fed and the Bank cut rates in a concerted attempt to settle the financial markets. Is a similar response likely this time round?

The consensus in the City is that it is too soon to say. Ms Bell said: "The Greenspan signal is, in my view, entirely sensible, but the UK does not feel the same sort of global responsibility as the US." Mr Wall at Deutsche said: "The answer is unknown, the international environment is so uncertain. But if the environment stabilises, [a concerted cut in rates] will not be necessary."

Simon Briscoe of Nikko Europe noted that many equity markets were still up on the year, while other observers said that the international authorities could well have had their fingers burned by their 1987 attempt to soothe the markets. Although the rate cut did help market sentiment, it was widely blamed for the subsequent inflationary boom in many developed economies.

For the first time in many months, the prospect of an interest rate cut is now seen by the City as a possibility - albeit an outside possibility - at this week's rate-setting meeting. A combination of domestic slowdown and market turmoil has put higher interest rates firmly off the agenda, say the experts. If the turmoil continues, the prospect of a rate cut stops being a possibility and becomes a probability.