Commentary: Interest rates call for strong nerves

The pressure on the Chancellor to do something - anything - to bind Britain's economic wounds is mounting by the day. The butchery of the coal industry, the fall in manufacturing output announced yesterday, the continuing redundancies in the private sector, and the expectation of another sharp rise of perhaps 40,000 in the unemployment total today all add up to a tempting case for faster, sharper interest rate cuts.

The drop in manufacturing, in particular, may be an unpleasant augury of a continued slide in the economy for the rest of the year. Recent CBI surveys have suggested that companies' stocks of unsold goods are continuing to build up, a situation that was likely to lead to a sharp retrenchment of production and jobs. The pattern of the manufacturing figures - with consumer and intermediate goods production down - is consistent with such a stock-led downturn.

But the fluttering in the Fleet Street dovecotes may still go unheeded unless the Bundesbank council obliges with another interest rate cut today. Despite the strength of the domestic case for further cuts in interest rates, a too-rapid progress runs the great risk of a counter-productive reversal. If the foreign exchanges come to perceive that British interest rates are fundamentally detached from those across the Continent, they are also likely to conclude that our commitment to lower inflation is fragile. The pound could easily begin to drop like a stone.

Now, there is a perfectly respectable argument which says that these are the ideal circumstances for a devaluation. The direct impact of higher import prices on inflation will be limited by the peculiarly depressed state of the economy. If the pound had not been forced out of the exchange rate mechanism, it is quite possible that inflation would have tumbled dramatically by the end of next year. Even if import prices rise directly in proportion to the fall in the pound, this will only serve to offset what would have been falls in inflation. We are still looking at inflation around 4 per cent at the end of next year, or perhaps even less. That is the lesson of episodes such as 1982 or 1986 when inflation continued to fall despite a sagging pound.

But the risk of a rise in inflation from present levels becomes real if there is a further fall in the pound, which is precisely why Bank of England and Treasury officials are worried about sharp interest rate cuts. Nor can the Prime Minister and the Chancellor ignore the example of Nigel Lawson, who relaxed policy after the 1987 general election and duly mistimed the electoral-economic cycle. Although they need strong nerves not to cut interest rates too rapidly, they would also need strong nerves not to raise them again if the pound went into free fall.