Interest rates stay on hold despite Brown's largesse

The City is divided over the Chancellor's scope for further vote-winning Budget handouts before the next General Election
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As experts struggled to get their heads round the implications of Wednesday's preBudget report (PBR) for fiscal and monetary policy, the Bank of England delivered its own verdict yesterday by keeping interest rates on hold at 6 per cent.

As experts struggled to get their heads round the implications of Wednesday's preBudget report (PBR) for fiscal and monetary policy, the Bank of England delivered its own verdict yesterday by keeping interest rates on hold at 6 per cent.

The outcome had been forecast with complete unanimity within the City. But the decision avoided the embarrassment to the Government that a hike would have caused, coming just a day after it announced handouts of some £4bn to pensioners, hauliers and car drivers.

Some economists have warned that the Chancellor's largesse - and any further handouts in the next Budget - could trigger further rate rises. But they said this would not come until after a likely election next summer.

In his PBR Gordon Brown, the Chancellor, unveiled extra spending measures and tax breaks that will cost the Treasury £2.6bn in 2001/02 financial year and £3.9bn in the following year.

He also announced consultation on a package of measures - mostly transport - that would add another £1.75bn to the annual spending bill.

At the same time he raised the forecast for the surplus by £4bn to £10bn for this year and £1bn to £5bn in 2001/02 - thanks to higher tax receipts and an underspend by Government departments. He also squirreled away about £1.6bn a year into a contingency reserve that could cover extra transport spending.

The Institute for Fiscal Studies, a leading economic think-tank, said Mr Brown had left himself no room to deliver a pre-election tax cut in next March's Budget. The IFS said Mr Brown could not use any more of the his forecast £10bn public finance surplus without breaking one of his "golden rules".

Carl Emmerson, a senior economist at the IFS said: "He has given away as much as he could have afforded to do. There's no additional money in the Treasury forecasts for extra spending or tax cuts."

However, it added that the outlook could change if the Treasury's forecasts for the public finances for the rest of the year turned to be overly cautious. Mr Emmerson said the only way to justify further tax cuts would be to raise the estimate of the long-term trend rate of growth - something that was done in the late 1980s and which contributed to the recession of the early 1990s. He said that raising the rate from 2.25 to 2.5 per cent could justify a £1.5bn give-away but warned the margin of error was too large.

The IFS declined to comment on the impact the PBR measures on interest rates, saying this was outside its remit. This baton was eagerly picked up by economists in the City. But there was a range of views yesterday.

They were divided into three camps: Those who believed rates hikes were now inevitable; those who believed a rate cut had now been ruled out and those still optimistic the next move in rates was down.

In the first camp, Michael Saunders, of Salomon Smith Barney, said rates would have to rise by half a percentage point next year. "If the Government ever manages to spend the money they plan to spend, then the fiscal stance will loosen markedly next year, supporting domestic demand," he said.

Philip Shaw, at Investec, said: "To his credit Mr Brown has not gone for broke to bribe the electorate as a short-term fix. But further ahead the measures are likely to add to existing demand pressures - without additional stimulus in the Budget." But he said the rate rises in the pipeline would come after a likely midsummer election.

For other economists, the key issue was whether Mr Brown was purposefully steering on the overcautious side when it came to forecasting the £10bn surplus.

John Hawksworth, head of macroeconomics at accountants PricewaterhouseCoopers, projected a £14bn surplus this financial year.

Geoffrey Dicks, at Royal Bank of Scotland, said that since the 1999/2000 financial year had produced a £16bn surplus, there was no reason why this year should not deliver the City consensus forecast of £15bn.

"By the time of the Budget - the last, one assumes, before the election - Mr Brown will have to own up to this £5bn," Mr Dicks said, forecasting this would be used for tax cuts. "All very plausible but it does add to demand and eventually the Monetary Policy Committee might not wear it," he said.

David Hillier, at Barclays Capital, said he was worried the higher surplus was due to the cyclical strength of the economy rather than a structural and unexpected improvement in economic growth.

"The extra revenue is cyclical and giving it away is unsustainable," he said. "Short-term rate cuts are off the cards .... It makes our rate call of 6 per cent for the next two years even more feasible."

Independent consultants, Capital Economics, said the package of handouts was "fully financed" by the improvement in the public finances.

Its managing director, Roger Bootle, said the structural Budget position had improved, which meant higher tax takes were adding to the fiscal tightening of the economy. "With growing signs of a slowdown in the activity indicators, we stick to our view that the next move in rates will be down," he said.

Business organisations that on Wednesday gave a cautious welcome to the macroeconomic implications of the PBR, applauded the Bank's decision to leave rates on hold.

Ian Peters, deputy director general of the British Chambers of Commerce, said: "This will bring a further boost to business confidence following the Chancellor's helpful pre-Budget, although what was announced may leave little room for more tax cuts or spending in the full Budget."