Cautious confidence on inflation prompts cut in rates

THE BANK of England yesterday shaved interest rates by a quarter of a percentage point to a fresh 17-year low of 5.25 per cent. The move came earlier than the City had expected but was smaller than the usual half- point reduction.

The move saw the FT-SE index of 100 leading London shares regain 21.1 points of the ground lost on Monday, but it closed well off its intra-day high at 3,440.2. The pound weakened against both the mark and the dollar, falling half a point against a basket of currencies to 81.5 per cent of its 1985 value.

Most City economists believe that rates still have further to fall, with the next cut likely after tax increases have taken effect in April. Roger Bootle of Midland Bank believes that rates will fall to 4 per cent, but a more cautious David Walton of Goldman Sachs expects a 5 per cent trough in mid-year.

The cut reflected the Bank's and the Treasury's belief that the outlook for inflation has improved, in part because of greater competition in the shops and the likely depressing effect on the economy of Budget tax increases. But the cut was also deliberately cautious because growth might turn out stronger than expected and higher taxes could push up pay settlements.

The cut was timed to coincide with the Bank's latest quarterly report on the Government's anti- inflation policy, but at the same time it showed that the authorities are happy to cut rates in Britain even if they are rising in the US and falling unexpectedly slowly in Germany.

The Bank said in its Inflation Report that underlying inflation had fallen unexpectedly since November and was likely to rise slightly this year before levelling out at over 3 per cent. But the Bank added that underlying inflation was more likely to turn out disappointingly high than unexpectedly low.

The Bank said the Government's preferred measure of underlying inflation - excluding mortgage interest payments - was likely to remain in the upper half of the 1-4 per cent target range if base rates were unchanged. Yesterday's cut is expected to raise inflation by only a tenth of a percentage point over two years.

The Bank believes that the Government's stated aim of bringing inflation into the lower half of the target band will require either higher interest rates or further lowering of inflation expectations among markets and wage bargainers.

The recovery is starting to narrow the gap between the economy's output and its potential, but the Bank does not expect growth over the next two years to be much more than the trend rate of 2-2.5 per cent.

The decision to cut rates was taken by the Chancellor following discussion with the Governor of the Bank last week, but the precise timing was left to the Bank. The Bank agreed with the move but was strongly opposed to the idea that rates should be cut by a full half point. Rates have not been cut by as little as a quarter point for 10 years, but the Chancellor said small moves were now more likely.

In a speech in Paris last night the Chancellor also said he was looking at ways to prevent the tax and social security systems encouraging people to stay on benefits rather than work. He is investigating 'basic income' schemes, which would pay everyone a lump sum before taxing all their income. In theory this could replace means-testing and help to prevent very high combined rates of tax and benefit withdrawal.

View from City Road, page 28

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