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Outlook: Interest rates

THERE ARE two schools of thought about how to run a successful independent monetary policy - the Federal Reserve's way of doing it and the Bundesbank's. In recent years, they have been equally successful. The differences and many and varied but they are best characterised in the following way.

At the Federal Reserve, Alan Greenspan always has half an eye on what Wall Street is up to and how the markets will react to his decisions. Then there is Hans Tietmeyer who in the proud tradition of German central bankers instinctively hates money changers, and believes that it is the job of a good central bank to ignore them.

Britain's monetary policy committee is still finding its feet. As the committee approaches next week's crucial interest rate decision, it will be weighing the two approaches in the the balance. Should it respond to the latest seizure in financial markets and the sharply deteriorating outlook for the world economy by cutting rates? Or should it ignore the siren warnings, and look only to its own number crunching for direction?

The differing approaches of Messrs Tietmeyer and Greenspan may have as much to do with their backgrounds as the very different economies they are charged to control. Mr Greenspan had a successful career on Wall Street before going into central banking, while Mr Tietmeyer came up through the world of politics.

But they also reflect the vastly different structure of the economies of Germany and the United States. For all the recent hoo-hah about Germans rushing to buy equities, the fact remains that while the German stock market could go pop bang and no one outside Frankfurt would notice, the 20% fall in the American stock market is another matter altogether. The impact on the real economy will be significant.

Mr Tietmeyer was in his element when he told a well-fed gathering of Frankfurt bankers this week that there was no sign of global economic recession and rejected calls for a rate cut to steady the markets' jangled nerves. Obviously, central bankers should be very mindful of the experience of October 1987 when the G7 cut rates in response to the crash only to find out later that they would have been better to leave well alone. The cut accentuated the latter stages of the boom and made the subsequent bust that much worse.

On the other hand, the Monetary Policy Committee has more than just the crisis in world markets to act on this time round. Even the overheated service sector is now slowing noticeably. In the US, Mr Greenspan has been happy to let the markets think the Fed will let US interest rates fall if there is any sign that the economy is being hurt by the Asian and Russian crises. The Bank of England should be doing the same.

One potential problem with this approach is that there is no obvious mechanism for it. At the end of the MCP's two day meeting, the Bank either raises rates, cuts them or leaves them unchanged. We don't know the thought process that went into the decision until the minutes are published six weeks later.

If the Bank decides, as seems likely, once more to leave rates unchanged, it should nonetheless attempt to find a way round this difficulty. A month ago it was still credible to claim that the balance of risks lay more in breaching the inflation target than Britain tipping into recession. Since then an awful lot has changed. It is not just the fact that stock markets are falling. The crisis in the Far East has been shown to be a lot more serious than we thought. Meanwhile, domestically, evidence of a slowdown continues to pile up. House prices are down, car sales are down, no one seems to be able to shift anything on the High Street. Commodity prices are at their lowest for decades. It is hard to see how the risk of inflation taking hold are greater at the moment than the risk of sliding into recession.