Interest rate cut may come this time

The long wait may soon be over. It is a full year since the Bank of England's monetary policy committee deemed it necessary to change interest rates but, as its nine members begin two days of deliberations this morning, expectations are running high that the cost of borrowing is coming down.

Several factors point towards a small cut in rates. For one thing, last month's vote was a real cliff-hanger, with the committee voting by the narrowest of margins for the 6% status quo. It would only take one of the five members who opposed a cut last month to swap sides for the balance of power to shift.

What is more, while there have been mixed signals coming out of the domestic economy, the international outlook has been deteriorating rapidly. The US Federal Reserve lopped a full percentage point off US interest rates in January amid considerable evidence that the country's economy has run into a brick wall. Only yesterday a survey claimed that US companies announced a record 142,200 layoffs in January.

Then, there is the fact that the Bank has undershot the government's inflation target. The MPC's mandate is specific: it is to keep inflation at 2.5%, no higher and no lower. Yet for almost two years inflation has been lower than 2.5% - not by much, but by enough and for long enough for some members of the committee to raise the subject at the last meeting.

Some of Britain's foremost economic forecasters believe that inflation is set to go still lower over the coming months, as last year's steep rise in petrol prices starts to wash out of the inflation numbers. The National Institute for Economic and Social Research believes that inflation will fall below 1.5% by the end of this year. "That will mean that the governor of the Bank of England will have to write an explanatory letter to the chancellor setting out how he intends to raise inflation."

It is a sign of how well-behaved inflation has been in recent years that Sir Eddie George has not been obliged to put pen to paper since the Bank was first given responsibility for setting rates in the spring of 1997. But it would certainly be easier for him to explain the MPC's failure to keep inflation high enough if he and his colleagues had already cut rates.

Finally, there is the political dimension. One of the main factors cited by Gordon Brown when he granted the Bank operational independence was that it would take the politics out of monetary policy. There would, the chancellor said, be no more messing around with interest rates in the run-up to elections. However, turning monetary policy into a purely technocratic affair may prove more difficult in practice than it would appear in theory. The next meeting of the MPC takes place just after the Budget, and cutting rates then would look like an endorsement of Mr Brown's fiscal policy. By the time the April meeting rolls around, the parties will probably be on the hustings and the highly charged political environment will make it even harder for the MPC to contemplate a change in rates.

As a result, unless rates are moved tomorrow, they may be stuck at 6% for the next three months. Given that monetary policy only works with a time lag, it might be argued that a short delay would not matter that much. But the US experience has indicated that in a modern economy there can be sudden and dramatic mood swings. Putting in place a confidence-boosting measure now will have its attractions to some MPC members.

Although that might give the impression that a rate cut is an odds-on certainty, tomorrow's decision is not quite as clear cut as that. Those who counselled caution at last month's meeting may not have seen much in the economic data in the meantime to persuade them to change their minds. The economy grew by only 0.3% in the fourth quarter, well below its potential, but there were a couple of special factors causing a slowdown in output from the energy sector and from transport in the chaos that followed the Hatfield rail crash.

Recent news from manufacturing has been mixed. Yesterday's industrial production figures for December showed manufacturing output up 0.3% for the second successive month, with the slow but unspectacular improvement reflecting the differing fortunes of Britain's various industrial sectors. The metal industries - as reflected in the big job losses announced by Corus - are suffering, but the hi-tech end of manufacturing is still doing well. Recent surveys from the Confederation of British Industry, the British Chambers of Commerce and the Engineering Employers Federation have all been slightly more upbeat, perhaps as a result of the slight fall in the value of the pound.

Roger Bootle, economic adviser to Deloitte & Touche says that tomorrow's decision will not be clear cut, but that the second reduction in the US last week, prompted by the precipitous collapse in confidence, removes the risk that the MPC will be seen as the Fed's poodle. "A rate cut now would be an insurance policy against similar falls in confidence over here, which may be more difficult to reverse than forestall."