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Markets bet on early cut in interest rates

The City is betting that Kenneth Clarke, Chancellor of the Exchequer, will cut interest rates after his meeting on Wednesday with Eddie George, Governor of the Bank of England.

Key economic statistics on retail sales, unemployment, earnings and inflation due out this week are expected to strengthen the case for a reduction in the cost of borrowing. Falls in German and US interest rates are also likely in the next few weeks.

Gerard Lyons, chief economist at DKB International, said: "I'd be amazed if the Chancellor doesn't cut."

Trading in London's financial markets at the end of last week showed that base rates are expected to fall by a quarter point to 6.5 per cent by the end of this month and to 6 per cent by the middle of 1996. The prudent Budget at the end of last month boosted these City hopes.

However, some economists were more cautious. David Miles, at Merrill Lynch investment bank, said: "If you take the inflation target seriously, and take the Treasury's optimistic economic forecast at face value, there is no case at all for a reduction in base rates."

Last week Mr George hinted he would oppose a cut in rates on Wednesday. Giving evidence to the Treasury Select Committee, he highlighted worries about the Ford pay offer becoming a benchmark for wage negotiations in January, a key month. He also expressed concern about the recent fall in the exchange rate.

Mr George drew attention to the fact that in its November Inflation Report the Bank of England forecast that the Government would miss its inflation target. Sterling has fallen nearly 2 per cent in value against other currencies since then.

Mr George even refused to admit that the Bank's advice to raise interest rates last May - rejected by the Chancellor - had been a mistake, despite the recent slowdown in the economy.

Steven Bell, director of research at Deutsche Morgan Grenfell, said: "The Bank clearly does not want a cut in interest rates." He said there was a 50-50 chance of a small reduction this week.

Alan Budd, the Treasury's chief economic adviser, had earlier confirmed that its optimistic forecast of 3 per cent growth next year was not based on lower interest rates.

However, David Walton, a Goldman Sachs economist, said Mr Clarke had shown himself to be his own man in the past. He found it difficult to see how Mr George could put up a strong opposition if the Chancellor wanted to move, given the recent evidence on the economy. By the time Mr Clarke and Mr George meet, they will have figures for retail sales, unemployment, manufacturers' costs and factory gate prices in November, and underlying earnings growth in October. They will also have an estimate of last month's retail price figures, due out on Thursday.

Headline inflation fell in October from 3.9 to 3.2 per cent, but underlying inflation (excluding mortgage interest payments) remained above the 2.5 per cent target.

Mr Bell said the strength of retail sales could be decisive, as the Treasury's optimism about the economy rested on a strong outlook for consumer spending. Last week a Confederation of British Industry survey revealed a high street at its most buoyant since April. On the other hand, expected interest rate reductions overseas will add weight to the arguments for a move in Britain.

The Bundesbank, whose council meets on Thursday for the last time before Christmas, is under mounting pressure to cut rates. But the president of the Bundesbank, Hans Tietmeyer, yesterday played down the need for lower rates to boost the economy.

The policy committee of the Federal Reserve meets on 19-20 December. It is expected to react to evidence of economic slowdown in the US if an agreement about the federal goverment budget is in sight by then.

Gavyn Davies, page 19