Surprise rate cut sends shares and sterling lower

THE MONETARY Policy Committee's decision yesterday to cut interest rates by a quarter point to 5 per cent caught the financial markets by surprise and sent the pound, shares and gilt prices lower.

The seventh fall in nine months, it took interest rates to their lowest level since November 1977.

In his annual Mansion House speech, Gordon Brown, the Chancellor of the Exchequer, said: "We have, as a result of decisive and timely action on the fiscal deficit and on interest rates, been able not only to steer a course of stability but to lay the foundations for high and stable growth and employment."

Many in the City concluded that this would be the last rate reduction in this cycle, however.

Neil Parker at Royal Bank of Scotland said the MPC had made a mistake as the economy was recovering strongly, and would need to reverse it. "This move could turn out to be very short term," he said.

On the other hand Michael Saunders, an economist at Salomon Smith Barney, voiced the minority opinion that the strong pound pointed to further rate cuts. "With the pound at this level, they need to create a boom in domestic demand," he said.

It was universally agreed that the uncomfortably high exchange rate explained the rate cut. Although it fell from earlier highs this week, the sterling index remains nearly 5 per cent up from its level at the start of this year. The index fell by 0.2 to 104.4 yesterday.

Shares and gilts reacted adversely, however. The FTSE 100 index ended 49.6 points lower at 6,403.4. Gilts also fell sharply after the Bank's announcement, with sterling futures pointing to a market expectation that borrowing costs will be on the increase by the end of the year. The long gilt yield climbed above 5 per cent to an eight month high.

"The markets certainly see this as the last interest rate cut in the cycle," said Nick Stamenkovic, a strategist at IDEA.

The Chancellor sympathised with exporters over the strong pound in his speech, but he emphasised that the MPC must focus on the inflation target and not target the level of sterling.

"The objective of British monetary policy is clear and unambiguous, with a symmetric inflation target," he said.

Eddie George, Governor of the Bank of England, also stressed in his Mansion House speech that there was no exchange rate target. "But we can and do aim to offset the impact of persistent external influences on the prospect for inflation," he said.

The Chancellor gave no new clues on the Government's policy towards the euro, saying the test of membership would be the national economic interest.

The Governor said the weakness of the euro should not be read as a verdict on the risks of the single currency. "The likelihood is that the euro will recover and some of the present tensions ease," he said.

The Bank's statement yesterday said: "Taking into account all the evidence on the inflation outlook, the committee judged that it is now more likely that inflation will undershoot the 2.5 per cent target."

Analysts speculated that the vote had been swung by Sushil Wadhwani, the new member of the committee. Minutes of the meeting will be published on 23 June.

Outlook, page 21