The Bank of England has become more optimistic about the outlook for inflation, but is warning the Government against a giveaway Budget.
Since its last inflation report in August, the Bank has shaded down its central projection of inflation in two years' time, although it still thinks it will narrowly exceed the Government's target of 2.5 per cent or less.
However, the Bank now accepts that "there is now a somewhat greater chance that inflation will be below 2.5 per cent in two years' time".
The Bank's chief economist, Mervyn King, said: "We will be Gladstonian in looking at the numbers" in the Budget. However, he also said the PSBR's failure to shrink so far this year could simply mean "we have started more slowly on the road of fiscal consolidation".
The gilts market reacted favourably, with the December contract rising over half a point. The short sterling contract also rose, indicating expectations of an easing in monetary policy. Some City analysts saw yesterday's Inflation Report as a clear sign the Bank had softened its line.
Ian Shepherdson, UK economist at HSBC Markets, said "Mr Clarke will be pleased with this report. If his Budget is neutral or tight, then the door will be open for lower rates in the New Year - possibly even before Christmas."
The report was published on the same day the CBI revealed that manufacturing production had fallen in the past four months in Scotland and the North- west. Nationally, manufacturing output was rising at its lowest rate for two years.
Mervyn King said that "the probability of hitting the inflation target has clearly risen since the August report".
This contrasted with the position earlier in the year, when the risks were "on the upside", meaning it was more likely inflation would come in above 2.5 per cent than it was that it would come in below.
The Bank identified three principal uncertainties about the inflation outlook. These were the prospects for demand and output, the puzzle of low earnings growth and the behaviour of broad money.
The Bank warned that the downside risks to output had increased, especially in the short run.
In particular, stocks had been built up further in the second quarter, increasing the risk of a temporary destocking cycle and accounting in part for the recent weakness of manufacturing output.
However, on balance the Bank expected some modest pick-up in domestic demand, which would essentially be sustained by a revival of consumer spending.
This forecast for consumption, which did not take into account any tax cuts in the Budget, was based mainly on the fact the impact of previous tax increases was drawing to an end. Consumption was therefore likely to return to growth at around its trend rate over the next year or so.
The principal danger in the labour market was that the low growth of earnings reflected an unsustainably low drift in wage rates rather than lower pay settlements. The gap between average earnings growth and settlements had virtually disappeared, but could rebound quickly with faster increases in bonuses or a period of stability in part-time work or overtime.
The Bank believed that the rate of growth of broad money - which had run at just over 8 per cent in the year to September - should turn down.
If sustained, however, it would foreshadow a pick-up in nominal demand that would eventually lead to higher inflation.
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