Industry given a breather

MANUFACTURERS are breathing sighs of relief at their reprieve from an interest rate rise this month. But economists believe their joy will be short-lived.

The Bank of England's rate setting committee opted to leave rates at a 38-year low of 4%. The European Central Bank followed by keeping eurozone rates at 3.25%.

Policymakers here and in Frankfurt are clearly reluctant to increase borrowing costs against a background of very low growth and a struggling manufacturing sector.

Corporate Britain is still fragile, as shown by the FTSE 100's drop below 5000 in the wake of more US business scandals. The eurozone picture is also gloomy.

Business and consumer confidence in Europe increased in May, but unemployment has also risen as manufacturers shed jobs. The European Commission cut its growth forecast last week for the second time in a month.

For the moment, worries about inflation are taking a back seat to the risk of knocking the economic recovery. The MPC, which yesterday celebrated the fifth anniversary of its inaugural meeting, has done a remarkable job in keeping inflation around its target rate of 2.5%.

We have become so used to price stability that the double-digit inflation days of the Seventies, Eighties and early Nineties have almost receded into folk memory. Nonetheless, hawkish noises are coming both from the Bank and the ECB.

Wim Duisenberg, the ECB president, warned that the outlook for inflation is less satisfactory than expected a few months ago. In the Bank's recent quarterly inflation report, it saw a near-70% chance that inflation would top the 2.5% target within two years.

Inflationary pressures may include rising wages and prices because of Gordon Brown's national insurance hike. Sterling weakness, which would make imported goods and services more expensive, is also a risk.

The pound followed the dollar down yesterday, sinking to its lowest level since October 1999 against the euro. The Bank is also coming under mounting pressure to slow down the consumer boom and the runaway housing market, where prices are now scaling such airless heights that borrowers are confronted with the prospect of mortgages that take 50 years to repay.

Most economists believe the Bank will not be able to resist rate rises for much longer.

US exposed

SUDDENLY, the American economy looks a little less than all-powerful. Foreign investors have cut back their exposure drastically since 11 September and since the Enron scandal exposed huge faults in US corporate governance, which the New York Stock Exchange is finally tackling.

The US Commerce Department says foreigners' investment slumped from £230bn in 2000 to £91bn last year. UK investment tumbled from £68bn to £11bn.

Fears that the US economic machine is losing momentum come on top of the heavy costs imposed by the terrorist attacks. The cost of combating terrorism and preventing another attack is likely to prove a serious brake on the US economy, exacerbating fears for the dollar. In a study, the OECD estimates that the cumulative loss to national income by the end of 2003 will be five percentage points of annual GDP, or £350bn.

The bill is already enormous. Destruction of physical assets cost private businesses £9.5bn and the government £1.5bn. Insurers face losses of £40bn.

US spending on defence had been falling. In 2000, it stood at just 3% of national income, around half its level at the height of the Cold War.

If public spending on the military and security increases by 1% of national income, and private spending by 0.5%, the OECD reckons that would reduce US output by 0.7% after five years.

Enhanced security measures could seriously dent world trade, adding to the costs of exporting. Developing countries, which need to sell goods abroad to grow, will be worst hit.