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THE OUTLOOK FOR INTEREST RATES

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Two events this week will be crucial in determining the Chancellor's scope for cutting base rates within the next c...
Two events this week will be crucial in determining the Chancellor's scope for cutting base rates within the next couple of months: the Budget on Tuesday and the meeting of the Bundesbank's Central Council on Thursday.

The Chancellor must deliver a Budget that the financial markets judge to be responsible fiscally, if he is not to dent hopes for an early cut in UK interest rates. This means that any cuts in personal taxes must be fully offset by cuts in planned public spending, or by increases in other taxes. It is also important that his spending plans and revenue projections are credible. If the markets do not believe them, they will react just as negatively as if the Chancellor had cut taxes without cutting spending too.

The key number in the Budget is the Public Sector Borrowing Requirement (PSBR), the difference between total government spending and revenues. In last year's Budget the Chancellor projected a PSBR of £13bn for 1996/97. By the summer his forecast had risen to £16.1bn, because revenues for this year were running below expectations. As economic growth has continued to disappoint, the market is now probably looking for a figure close to £20bn.

If the Chancellor's latest projection is close to £16bn (and is credible), an early cut in interest rates, probably following the December 13th meeting of the Chancellor and the Governor of the Bank of England, would be seen as inevitable.

On the other hand, a PSBR projection well above £20bn would cause a negative reaction in the markets. They would fear the Government had relaxed policy and was taking risks with inflation in order to boost its popularity ahead of the general election. One consequence would be a fall in sterling, which would make it harder for the Chancellor to sanction lower interest rates.

The Bundesbank meeting is also crucial to the outlook for UK interest rates because of its impact on the exchange rate. If the Bundesbank agrees a cut in official German interest rates this week, it will be easier for the Chancellor to implement an early cut UK interest rates without risking a fall in sterling's exchange rate relative to Continental European currencies.

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