Fed warns of economic weakness

The Federal Reserve added to the Bank of England's interest rate dilemma last night when it left American borrowing costs on hold but warned that the world's biggest economy was prone to further weakness.

Leaving US interest rates unchanged at their 40-year-low of 1.25%, the Fed said the so-called "Baghdad bounce" since the end of the war in Iraq had been disappointing, but there was not enough evidence as yet to warrant an easing of monetary policy.

The decision came on the eve of a gathering of the Bank of England's monetary policy committee, which will decide whether recent poor economic data justifies a cut in UK interest rates from 3.75%.

Data out yesterday pointed to a mild pick-up in Britain's service sector last month, but the rebound failed to quieten calls by some in the City and industry for action to boost flagging economic growth.

The TUC joined the chorus of demands for a rate cut tomorrow to keep the economy on course. TUC general secretary elect, Brendan Barber, warned that this was "not a time for complacency".

"A 0.25% cut would help secure the recovery of the UK economy and act as an insurance policy against delay in economic recovery in Europe," Mr Barber said, echoing CBI director Digby Jones, who last week called for a cut to boost industry.

However, some City analysts feel the wait-and-see approach taken by the Fed will increase the chances of a similar course being taken in London, with the MPC using concern about the impact of weaker sterling to justify a delay in changing monetary policy.

In the statement announcing its decision, the Fed said "recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing".

It added, however, that the end of the conflict had led to lower oil prices, stronger consumer confidence and a recovery in financial markets. "These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time."

Hinting at the possibility of a rate cut at its June meeting, the Fed's open market committee said there was a greater risk of inflation falling than of it rising. "The committee believes that, taken together, the balance of risks to achieving its goals is weighted towards weakness over the foreseeable future."

In the UK, the Chartered Institute of Purchasing and Supply said its monthly index of activity in the non-retail service sector - which includes hotels, restaurants and IT service providers - had pulled above the break-even 50 mark. April's reading was 50.7, up from 49 in March, with new orders still decreasing, but at a slower pace than in March.

City investors appeared to take heart from the optimistic outlook and followed Wall Street upwards to break through the psychologically important 4,000 mark. The FTSE 100 closed 53.8 points higher, at 4,006.4 - the first time it had passed 4,000 since January.

Although growth in the first quarter was just 0.2%, Michael Saunders, economist at Citibank, said higher equity prices, together with weaker sterling and falling oil prices, should provide concerted support to the economy, helping to correct the recent slowdown now that war in Iraq is over.