The City last night forecast that Kenneth Clarke, the Chancellor, will resist raising interest rates for the time being and brazen it out with the foreign exchange markets despite the worst inflation news for two years.
Retail price inflation last month climbed above 3 per cent for the first time in more than two years. At the same time, an unexpected sharp fall in retail sales confirmed the recovery was weakening, putting the Government in a dilemma over interest rates.
Figures on the labour market highlighted the same contradiction between higher inflation pressure and a weaker economy. Unemployment fell by 27,500 to 2.4 million, or 8.5 per cent of the labour force. Although this is the lowest rate since August 1991, the drop in joblessness was far smaller than in recent months.
On the other hand, unit labour costs in manufacturing rose 0.7 per cent in the year to December - the first rise after seven monthly declines.
The mass of economic statistics left the financial markets concerned about how the Government would react. They concluded that, on balance, the next rise in base rates had retreated but would still need to take place by early summer.
The pound drifted above DM2.35, a psychologically important level, after the turbulence earlier in the week. Gilts and short sterling, used to bet on short-term interest rate moves, rallied. Shares closed slightly higher, helped by a record day on Wall Street.
Geoffrey Dicks, chief UK economist at NatWest Markets, said: "The interest rate decision is finely poised. The odds moved in favour of a rise after disturbing producer price figures on Monday, but they have now moved back again."
Either way, currency analysts could find little reason for optimism about the exchange rate, which has been weak since the new year. Neil MacKinnon, Citibank's chief economist, said: "Sterling is the fall guy." Higher interest rates would dent the economy and renew concerns about the Government's political viability. But a delay in raising base rates would make the pound less appealing to international investors.
David Owen, UK economist at Kleinwort Benson, said: "There is a lot of feedback from overseas investors that they are worried about politics and economic policy in Britain."
Kit Juckes, currency analyst at SG Warburg, agreed that the outlook for sterling was depressed: "This is not a crisis but the foreign exchange market will struggle to find anything positive in the news that inflation is going up and growth is slowing down," he said.
The FT-SE 100 index ended the day a fraction higher. Alison Southey, equity strategist at Nomura, said: "Equities are poised to go lower. There is bad news about inflation that is not already priced into the market."
Mark Brown, at Hoare Govett, said: "Shares are trapped in no-man's land between inflationary pressure and weaker demand." But he thought a favourable results season would help share prices recover.
The real surprise in yesterday's array of figures was a 0.9 per cent drop in the volume of retail sales in January. There was some caution about the one-month figure because of the difficulty of adjusting for Christmas and the dismal weather last month. Even so, the underlying rate of growth in sales volumes - the change in the latest three months compared with the previous three - was the lowest since April 1992, the depth of the recession. Sales fell in all categories except household goods.
Retail price inflation rose to 3.3 per cent last month from 2.9 per cent in December. Almost half the jump in this year-on-year rate was accounted for by a fall in mortgage rates in January 1994. The RPI was unchanged during the month: higher excise duties announced in the Budget and mini- budget and higher prices for some foods were cancelled out by January sales.
The increase had been expected but nevertheless worried some economists. Keith Skeoch, chief economist at James Capel, said: "There was much less discounting on the high street than there was last year."
There was also some consternation that the Central Statistical Office is to drop the old tax and price index from its news release on inflation in favour of the measure excluding mortgage payments and indirect taxes known as RPI-Y. The tax and price inflation rose 3.9 per cent in the year to January, while inflation measured by the RPI-Y is below 2 per cent.
Yesterday's information on the labour market brought some bad news on wage costs. Underlying average earnings growth was estimated to be unchanged, at 3.75 per cent. But earnings in industry rose 5.7 per cent in the year to December. Labour costs per unit of output in manufacturing were 0.7 per cent up over the same period, after falling since the spring.
The buoyancy of manufacturing was confirmed by a 15,000 rise in jobs in December. In the fourth quarter employment in manufacturing increased by 37,000, the biggest rise since 1978. But total joblessness fell 27,500 in January, after seasonal adjustment, below the average of 40,000 a month in the past six months.