Bank repeats warning that long-term inflation target will not be met

The Bank of England is poised to raise the stakes in its clash with Kenneth Clarke with a renewed demand, in its Inflation Report tomorrow, for interest rates to rise. But the Chancellor is now widely expected to put politics first and avoid increasing borrowing and mortgage costs before the election.

Treasury officials admit privately that the Chancellor has not paid any attention to their internal advice for some weeks. "We don't know ourselves what he's going to say when he goes into the monthly meetings," said one.

Some Treasury officials, like the Bank of England, believe that the strength of the economy means base rates ought to rise to keep inflation on course for its target in the longer term.

One Treasury adviser, "wise person" Tim Congdon of Lombard Street Research, went further yesterday. In a report to clients he wrote: "British monetary policy is deviant and irresponsible, just as it has been on so many occasions in the past. It will lead over the medium term to higher inflation."

However, recent weakness in some of the monthly economic statistics has given Mr Clarke plenty of ammunition. The Chancellor could not conceal his delight at figures yesterday showing that inflation at the factory gate had fallen to its lowest for a generation.

"As I was driving to work this morning the producer price data were released, which were staggeringly low," the Chancellor said. In a speech yesterday he said economic prospects were the best in living memory.

Mr Clarke said the recovery had reached all regions, which meant it could be sustained for longer. "It means the economy can sustain higher levels of activity without running into inflationary buffers," he said.

There was additional support yesterday for his decision not to increase interest rates after last week's monetary meeting from a survey of high street retailers. This showed that retail sales growth picked up last month after a weak December but remained below last summer's rapid pace.

The British Retail Consortium said the strong pound meant tourists visiting London were doing less shopping. Food and drink sales were weak but the sales performance in other areas was good. Andrew Higginson, chairman of the BRC's economic affairs committee, said: "The latest figures point to a healthy picture for the economy as a whole. The value of retail sales has now stabilised."

Separately, official figures yesterday showed that the increase in "core" prices charged by manufacturers was 0.6 per cent in the year to January, the lowest rate of inflation at the factory gate since 1967. Output prices rose 0.3 per cent during the month before adjusting for normal seasonal variations - a very subdued increase at the time of year when manufacturers usually push through increases in their list prices.

A decline of 0.6 per cent in the price of raw materials in January, in large part due to the strength of the pound, helped explain the extremely good output price inflation figures. This took them to a level 6.2 per cent lower than a year earlier.

Analysts in the City said the latest economic news had vindicated Mr Clarke in the eyes of the financial markets.

"These figures were truly excellent from the Chancellor's perspective," said David Owen, an economist at Kleinwort Benson. "The exchange rate is clearly having a bearing on the economy."

Michael Dicks, UK economist at investment bank Lehman Brothers, said: "The Bank of England will have to make out the case for ignoring the rise in sterling since its last Inflation Report. It will not be as persuasive this time around."

Although some City experts agree with the Bank - and Treasury - view that base rates should go up now for the sake of the longer-term inflation target, most expect to see very favourable inflation figures for the next few months. "Short-term there is no reason to worry about inflation," said Kevin Darlington at Hoare Govett.

Comment, page 21

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