Sterling is the key to any further rate cuts

The cut in the Bank of England's key interest rate by a further quarter point to 5% caps a remarkable few days for the global economy. Finance ministers from the group of seven, who gather in Frankfurt tomorrow, will be able to reflect on a global recession which has been avoided - before moving on to the ticklish issues of third world debt and Kosovo.

Here in the UK, the monetary policy committee's latest rate reduction decision, which has brought rates down from 7.5% last October to 5% now (the lowest level since the 1960s), will come as further relief to industry. Hopes that manufacturing would be able to fight its way back from slump, without the assistance of a competitive exchange rate, have proved unfounded. As the governor of the Bank of England, Eddie George, made clear in his Mansion House speech last night, the objective of the latest rate cut was to offset the exaggerated rise in sterling.

The flat output figures show how much industry is suffering. In the three months to April manufacturing output fell by 0.1% at an annualised rate and industrial production 1.2%. Moreover, the evidence from surveys of the high street, such as the British retail consortium, suggests that business there is also stagnant. The only part of the economy showing any signs of life at present is housing - but that phenomenon is confined largely to London and the south-east.

While the flatness of the economy may have encouraged the monetary policy committee to reduce rates, the decisive factor was the exchange rate as the governor indicated. The bank made it clear in its May inflation report that sterling's strength against the euro and other currencies would likely lead to an undershoot of the 2.5% target rate: since then the pound (in common with the dollar) has strengthened further against the euro (by about two percentage points) making a rate cut all but inevitable.

A strong pound has both the effect of suppressing inflation (by reducing the cost of imported goods) but also making it harder for exporters. So a rate cut both helps the bank to hit its target and offers fresh hope to the struggling export sector. A point not lost on the chancellor, who in his Mansion House speech noted exporters' concerns. However, he insisted that an inflation target was the right way of managing the UK's monetary policy, rejecting the exchange rate targets last used in the Lawson era.

But has the bank made a mistake? There is now a view (reflected on these pages) that the worst of the euro weakness is over and that the pound will weaken in the coming weeks and months. The trigger for this turnabout is the pick-up in German gross domestic product (up 0.4% in the first quarter) and the return to euroland confidence expected to be triggered by the end of the Kosovo war.

Perhaps, But that could be a misreading of the runes. The maximum impact of the Kosovo conflict, as was the case with the Gulf war, could come in the months of uncertainty as UN troop deployments take place and the complex political settlement in the Balkans is implemented. The case for holding off, because the Kosovo deal will lead to a more permanent upward adjustment in the euro, is a weak one while the growth differential between euroland and the US is so wide.

With the recovery so sensitive to the exchange rate, the MPC made the right choice. It just so happens to be giving a further lift to the British economy at a moment when the situation across the rest of the group of seven is also looking better. The uptick in Germany demonstrates how in an exporting economy a more competitive exchange rate can make a real difference, particularly when pushing on the door of recovering emerging market economies.

But the even bigger global fillip is the possibility that Japan may be emerging from its worst slump since the second world war. Assisted by a further loosening of monetary policy and a great deal of fiscal stimulus the Japanese economy managed to grow at 1.9% in the first quarter of 1999, after a drop of 0.8% in the previous quarter - a much better performance than anyone had expected.

Having been through so many false dawns the authorities in Tokyo were clearly anxious to play down the figures, and the Bank of Japan intervened to prevent the yen rising, in what was seen as a clear indication that the GDP figures are giving too optimistic a reading.

This will also concern the Group of Seven. Although there have been some signs of restructuring in Japanese finance and business - partly symbolised by the decision to allow the UK's Cable & Wireless to buy International Digital Communications - these are very early days. Nevertheless, signs that two locomotives of much of the past 50 years - Germany and Japan - are starting to function again will be a source of some relief. If the UK is to recover it needs this since a stronger Germany and Japan will take some of the upward pressure of the UK exchange rate, as well as reopen some export markets.

The concern of some economists, notably Marian Bell of Royal Bank of Scotland, is that MPC will provide too much growth stimulus and overheat the economy. As far as inflation is concerned one of the big worries, higher oil prices, has eased back somewhat. If there is an inflation worry in Britain it stems from the labour market where pay settlements and average earnings could be a source of concern, especially if growth were to takeoff.

For the moment, however, the monetary policy committee is doing exactly as it has been tasked, by treating the inflation rate as a symmetrical target, which has give it the chance to lower rates again. Whether this is the last rate cut or not, however, will depend largely on the pound. If the latest interest rate cut, together with recovery elsewhere in Europe causes it to ease down, then 5% may be the bottom for the moment. If it does not, house-buyers may yet see further mortgage cuts, although these will be limited by the need to protect savers' returns.