Outlook: Rate conundrum

CLICHE OF the week in the City is that the Monetary Policy Committee's decision on interest rates this week is finely balanced. On one side of the scales lie signs of mounting domestic recovery. Confidence is up, the housing market has returned to boom conditions, industrial orders have recovered, and so on. On the other side weighs the strong pound and the need further to cut interest rates so as to deflate its value a little.

After last month's equally finely balanced decision not to cut the cost of loans, the MPC issued a statement indicating that the exchange rate could yet tip the balance in favour of lower rates. Since then both sides of the scales have got heavier. But the mere fact that the pound has put on another 2 per cent since last month will have the usual suspects baying for a rate cut.

Unfortunately, there is very little chance a decision by the MPC to cut rates by a quarter or half point would bring the exchange rate down to a more comfortable level. But that does not mean there is no case for responding to the impact the higher pound will have on inflation. Through its direct impact on import prices and indirect effect through lower export and output growth, it means inflation will be lower than it would have been at last month's exchange rate.

However, there is a difficulty with trying to offset this through monetary policy, in that any such action involves building up greater domestic inflationary pressure. Once stoked up, this is hard to subdue again.

Indeed, to cut interest rates for this reason could be regarded as a highly risky tactic if you believe there is a good chance that the pound will weaken sharply as a result, thus reversing the helpful disinflationary effects of a strong pound. This was the argument that tilted May's MPC decision in favour of no change.

It is hard to say which way the vote will go this time, as it probably depends on Sushil Wadhwani, the new member. But with the economy gently picking up momentum, holding rates unchanged for a bit longer would probably do no harm.