Bank warns of inflation danger from VAT rises: Lower interest rates may accompany spending cuts or tax increase

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THE BANK of England warned yesterday that increases in VAT next year could help to push the Government's preferred measure of underlying inflation above its 4 per cent target ceiling.

But the Bank left open the possibility of an interest rate cut to accompany tax increases or public spending cuts in the Budget later this month, having advised the Treasury privately to raise a further pounds 7bn or so over the next three years.

The Bank said in its quarterly report on anti-inflation policy that underlying inflation - excluding mortgage interest payments - was likely to remain within the 1-4 per cent target range set last year. Officials believe any breach resulting from tax increases would be temporary, but fear that higher inflation could become entrenched if it was used to justify big pay settlements. This might demand higher interest rates in response.

The Bank raised its forecast for underlying inflation for coming months, following unexpectedly high figures over the summer as sales ended and seasonal food prices rose. Underlying inflation is expected to rise from its present 3.3 per cent to above 3.5 per cent early next year before falling again. Headline inflation 'will rise rapidly from its present low levels, as the effects of last year's cuts in mortgage rates drop out of the monthly comparison'.

Officials at the Bank believe interest rate policy should now be guided by underlying inflation excluding indirect and local authority taxes as well as mortgage interest payments. The Chancellor of the Exchequer and Governor of the Bank have recently taken the heat out of rate cut speculation by saying that conditions do not justify lower rates.

Traders in the gilts market now believe the Government is set to keep inflation just within its target ceiling in the long term, but the Bank warned that 'they do not yet indicate full faith in price stability'. Gilts trading was nervous after the inflation report was published in late afternoon.

The Bank said in the inflation report that confidence in the Government's anti-inflation policy required steady progress in cutting government borrowing. In evidence to the House of Commons Treasury Select Committee, the Bank's Deputy Governor, Rupert Pennant-Rea, argued that credibility would also be enhanced by giving the Bank freedom to set interest rates without Treasury interference. Mr Pennant-Rea said that a Parliamentary mandate charging the Bank with maintaining price stability would lead to lower inflation. He said the marginal gains in the Bank's autonomy so far - such as the recently won freedom from the Treasury in writing its inflation report - would be no substitute for statutory independence.

Pressing the case for early independence, he warned that in a period of large annual budget deficits any government would over time find the temptation to allow inflation to rise difficult to resist. Mr Pennant-Rea reaffirmed his interpretation of the Government's inflation targets as narrowing to 1-2.5 per cent by the end of the Parliament, in 1996 or 1997, from the present 1-4 per cent.

The Deputy Governor said he favoured a system of independence in which Parliament charged the Bank with a broad mandate to pursue price stability. This should be supplemented with a 'strategic objective' for inflation over a limited time period, set by the Government. It would establish, for instance, a target for inflation of between 0 and 2 per cent. 'I do not see it as appropriate or desirable for a central bank to be utterly independent of you, the elected politicians,' he said.

But aside from unforeseen events like oil price shocks, Mr Pennant Rea said an excessively liberal strategic objective would be incompatible with the statutory mandate and thereby limit a government's ability to vary inflation targets.

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