George treads difficult line

The eyes of the City will be on the Bank of England today as it unveils its quarterly inflation report. After the widespread perception that the Chancellor overruled Bank of England Governor Eddie George last week on a rise in interest rates, attention will be focused on the Bank's new projection for inflation over the next two years.

The key question is whether the Bank still thinks the Government can meet its ambitious target of 2.5 per cent or less for the underlying rate of inflation by the end of this Parliament.

Dealers will be looking for any sign of disagreement between the Chancellor and the Governor following a day in which the pound recovered by 2 pfennigs against the mark but fell by a further cent against the dollar.

In particular, they will be scrutinising the report for evidence that the Bank is taking a gloomier view on the prospects for inflation following the fall in the pound of 6.5 per cent against a trade-weighted basket of currencies since the start of the year.

Mr Clarke came out fighting yesterday to defend his controversial decision to keep interest rates on hold. "I'm not a Chancellor who ever has been or ever will be driven off the right economic course because of short- term political pressures," he told the annual Scottish conference of the Conservatives party.

In an interview with the BBC, he said that sterling's performance depended on the fundamentals of the economy. "I don't have an exchange rate target," he reiterated.

With such high stakes, it is unlikely that the inflation report will lay concerns on the line. It is not in the Bank's interests to precipitate a full-blown sterling crisis. In this sense, the Chancellor is likely to succeed in calling the Governor's bluff in the short run, suggests Roger Bootle, chief economist of HSBC Greenwell. Any worries are likely to be heavily coded and between the lines.

But success for the Chancellor could prove short-lived if sterling continues to slide or if the economy turns out to be growing more strongly than Mr Clarke thought last Friday.

The danger is that he might be forced into a panic increase in interest rates to convince the markets that he is serious about inflation. If that happened the rise could well be more than had he acted on Friday.