View from City Road: UK rates feel wind of change from Germany

The prospects for lower UK interest rates improved again with yesterday's half-point reduction in the German discount rate. The surprisingly bold move brought German official rates in line with British ones at 5.25 per cent. If the pound strengthens as a result - as it began to do yesterday - the Chancellor will have yet another justification for the larger rate cut that he wanted and that the Bank of England resisted.

On the domestic front, Kenneth Clarke can point to better than expected inflation and worse than expected output, retail sales and unemployment.

On the external front, the fall in German interest rates helps to limit the potential downside of any movement in sterling, and hence any rise in import prices. With the pound down 1.7 per cent (measured by the trade-weighted index) since the last rate cut, this is not a negligible factor.

Indeed, the pace and extent of the decline in German interest rates is likely to give us substantial clues about what may happen in Britain. Despite yesterday's move, German rates are likely to come down only slowly. The German discount rate was cut but the Lombard rate, the upper end of the interest rate corridor, was left unchanged at 6.75 per cent thereby widening the interest rate band.

The repo rate - the real money market rate at which banks borrow - was also left unchanged. It is likely to be brought down cautiously from the current 6 per cent, and could hover just above 5.25 per cent for some time before the Bundesbank feels the need to chop away at the discount rate again.

Yesterday's reduction was fiercely debated by the Bundesbank council. Several members are clearly worried that the Bundesbank's target of 2 per cent inflation may never be achieved because of rising rents and higher prices for houses and other assets. There is also upward pressure on prices from higher indirect taxes at national and local levels, probably with more to come after this year's elections are safely out the way.

None the less, inflation has eased - down from 4.4 per cent a year ago to 3.5 per cent today - and will continue to do so. With the weakness of the domestic economy, this suggests that the discount rate may drop to 4.75 per cent by the summer and to 4 per cent by the year end. That would be well above the previous cyclical trough of 3 per cent in 1986, when inflation went negative.