Small cut - deeper wounds?

After 14 months of standing pat, the first move was always going to surprise somebody. But last week's quarter per cent cut in base rates by the Bank of England was a rude awakening for the slumbering legion of City economists.

In fact it was the last of a trio of shocks intended to boost confidence in the economy, and crucially, in the markets. First the Financial Services Authority made a high profile relaxation of solvency laws for insurance companies. Then Chancellor Gordon Brown talked up economic prospects in a speech to the Social Market Foundation. And on Thursday it was the turn of the Monetary Policy Committee to chip in with interest rates last seen 48 years ago. The markets barely moved - the FTSE 100 closed just 32 points up on the week at 3599.

The markets did not take the unexpected rate cut well. Collectively the City economists had also fallen into the trap of assuming a cut would always be communicated to them through speeches.

So out came the excuses: that there is something the MPC knows that we do not and, failing that, it was wrong and 'gambling everything' on the housing market.

In an explanatory paragraph attached to notification of the decision, the Bank of England said: 'Over the next two years, the prospects for demand, both globally and domestically, are somewhat weaker than previously anticipated'.

So which camp is right? For many economists who are not paid to guess what the MPC does, both are.

Stephen Radley of the Engineering Employers' Federation said the decision was a 'splendid one', that captured the current fashion for acting preemptively. 'It's a sensible action because the economy is slowing down not just in manufacturing, but survey evidence for the service sector and general employment is going sour.'

Earnings growth and new job vacancy statistics are set to disappoint. But the key factor was increasing evidence of weakening in the world economy. It is the economic failure of key export markets combined with the high value of sterling against the dollar that has pounded UK manufacturers deeper into recession. But even the latest statistics fail to show any calamitous drop - industrial production figures were bad, but came in line with expectations.

So what has the Bank seen? It has got a wide array of regional agents, who may well have noticed that demand conditions have weakened dramatically.

But not everyone is convinced.

The latest MPC minutes stated that, should downside risks crystallise from abroad, they could be dealt with abroad.

'So, on their own, the revisions to the global outlook would probably not have triggered the cut,' said Alan Castle, UK economist at Lehman Brothers.

Martin Weale of the National Institute for Social and Economic Research said: 'The best explanation I have is that they have got scared about the stock market slump - which shows a certain asymmetry because they weren't putting them up during the boom.'

If this is true, then the Bank will win qualified plaudits from campaigning economists and parliamentarians who want it to take greater notice of the role of asset prices in setting monetary policy.

But Weale believes that such considerations need 'a full and technical treatment' rather than an ad hoc approach. Similarly, the FSA's regular lifting of insurance company solvency requirements creates unwanted side-effects.

But the rate move does shed light on two issues. First, with war in Iraq still looming, an oil price spike and associated trickle through to inflation is more likely. But last week's cut shows the MPC is not in too much of a panic over the prospect of an oil price hike. And then there is the euro. A cut is an undeniable plus for the pro-euro campaign.

But for now all eyes are on Wednesday's quarterly Inflation Report.

The key issue is whether the Bank cut on the basis of concerns for financial stability. The Bank, FSA, and Treasury all meet in a monthly standing committee on financial stability. All tried to help gee up the markets last week. Bank deputy governor Sir Andrew Large sits on the committee and on the board of the FSA. The other deputy, Mervyn King, is a hot favourite to have voted against the cut, and faces a stern test at this Wednesday's Inflation Report launch.