Interest rate cut may lead to sterling slump

London Briefing: True to form, one or two, er, non Anglo-Saxon commentators have leapt on the economic slowdown in the UK as evidence that the much-vaunted superiority of the British economic model was always a myth.

A bit early to be claiming victory perhaps - the UK is still growing faster than most of Euroland, for example - but never let facts stand in the way of Panglossian views of Europe's future. A temporary slowdown in the UK looks like being accompanied by one of Europe's attempts at a cyclical expansion. This much we know, the rest is pure speculation. Wolfgang Munchau of the Financial Times, for example, in heralding an imminent comeback by the German economy, clearly sees the old order about to reassert itself.

Germany's economic problems, essentially a decade-long phenomenon at this stage, will be seen as a mere aberration, while the UK's century-long relative economic decline was merely attenuated by just another very temporary consumer boom.

Fourteen years of uninterrupted British economic expansion was simply the result of a deranged consumer out on a credit card-fuelled borrowing binge.

With the natural order of things rapidly being re-established, the debt-laden economic hooligan that is the average British shopper is now reining in his horns. German exporters are, by contrast, apparently about to show a clean pair of heels to all their global competitors, while downtown Frankfurt is about to see the start of late-night shopping (you have to have been there at 8pm to appreciate the monumental significance of this).

While this is all good knockabout stuff, it conceals a very real debate, one that embraces such arcane topics as the state of the business cycle and relative rates of potential GDP growth. Put bluntly, Britain looks to be in the middle of a cyclical slowdown, while Germany could be on the verge of an upswing.

Most rational economic commentators would, however, estimate Germany's probable rate of sustainable growth to be around 1 per cent, while that of the UK is nearer to 3 per cent.

But when both economies are, thanks to cyclical forces, both growing at 1 ½ per cent, as seems likely at some point quite soon, people like Munchau will undoubtedly lay spurious claim to vindication .

In response to short-term economic weakness, the Bank of England will almost certainly cut interest rates tomorrow. A lot rides on the economy's response to that and future cuts.

If there has been structural improvement, then current problems will quickly dissipate and the economy should pick up again quite quickly.

It will be critically important to observe the behaviour of capital spending in response to the rate cuts. Weak investment spending has been Gordon Brown's second biggest disappointment of late and he badly needs a capital spending- not consumer-led recovery.

If, by contrast, both corporate and consumer spending turns out to be underwhelmed by easier monetary policy, there will be lots of "we told you so" type comments from those itching to see the UK take a tumble.

One very important market that has greeted this debate with a bit of a yawn has been the foreign exchanges. Sterling was doing quite well against the euro until the first terrorist attack in early July when it weakened, roughly to its current level. For the first time in a while I am quite worried about sterling, not least because the cyclical forces outlined above point clearly to a further fall in the pound. If I am wrong on the structural arguments, it will be curtains for the currency.

And the trouble with structural forces is that they can, for quite a while, be confused with their cyclical counterparts.

Something that, with the benefit of years of hindsight, turn out to be a purely cyclical affair - "Gosh, didn't that deep slowdown sow the seeds of a wonderful boom" - might prompt sterling to have one of its periodic swoons.

Markets know that UK interest rates are on the way down and are beginning to think about rate hikes in Europe. If the ECB starts to signal an early tightening, then this could be the catalyst for quite a sharp depreciation of sterling.

In addition, if the Bank of England hints that this would be a welcome development, then the fall could be quite pronounced and this, I suspect, is exactly what the UK central bank is seeking to engineer.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.