City sniffs a rate cut as sterling strengthens

The City was last night poised for further cuts in interest rates after sterling's return to favour on the foreign exchanges removed a key objection from the Bank of England to lower borrowing costs.

With the pound gaining ground against both the euro and the dollar, dealers said the door was now ajar for a quarter-point reduction from the monetary policy committee either next month or in August.

Sterling's weakness since the start of the year was cited as a reason for leaving rates on hold earlier this month. The MPC meeting minutes, published yesterday, showed six of the nine members voted against a 0.25-point easing from the current 48-year low of 3.75%.

Since the decision on June 5, however, sterling has regained some lost ground, underpinned by the relatively robust performance of the economy, the widening gap in interest rates with the eurozone and the weakness of the dollar. Last night the pound was trading at just under $1.70 against the greenback - its highest level for almost five years - and at 69.61p per euro, was well off its recent lows against the single currency.

"Sterling is really the big story now, and the market is looking at it differently than it did earlier this year," said Michael Metcalfe, a senior strategist at State Street in London. "It is putting a premium on policy flexibility as the US is running out of options and the eurozone is bound by other issues, such as the stability and growth pact. The UK may be able to respond better [to problems]," he said.

Analysts pointed out the hawks on the MPC had justified their caution by stating that sterling was 1.5% lower at the time of the June meeting than anticipated in the Bank's May inflation report. But since then, the pound's trade-weighted index against a basket of currencies had moved back above levels forecast in the report.

Sterling's rise is likely to be seized on by the MPC members who voted for a cut this month - Kate Barker, Marian Bell and Steve Nickell. Even with the pound at a lower level than it stood at last night, the effect of "sterling's depreciation to inflation was likely to be muted", they argued.

In a "finely balanced" decision, MPC external members called for a cut in rates on the grounds that weakness in the global economy was spreading to Britain. The only external member to vote against a cut was newly appointed Richard Lambert.