Growth warning for the Chancellor

THE CHANCELLOR of the Exchequer is underestimating the likely impact of tax increases and the recent turmoil in the bond markets on economic growth next year, according to an independent analysis using the Treasury's own computer model of the economy.

Economic growth is likely to run at about 3 per cent this year before decelerating to between 2.25 and 2.5 per cent in 1995, says the Ernst & Young Item Club. The club is also more pessimistic than the Chancellor on inflation, predicting that the annual rate of price increases will have topped 3 per cent by the end of the year.

Item argues that this will trigger a rise in interest rates to 6.5 per cent - one and a quarter points above the current level - by the middle of next year.

'This is sufficient to slow inflation but is a much smaller rise than the financial markets expect, and probably smaller than the Bank would like', the report argues.

The Chancellor is expected to loosen control on public sector pay, which will result in him overshooting his public spending targets. However, the impact on the public sector borrowing requirement is likely to be masked by the current strong growth of the economy, leaving scope for cuts in income tax of about pounds 3bn in the November 1995 Budget. But Item also warns that the outlook for the economy could be much worse if the financial markets are right about the risk of higher inflation. If commodity prices surge and skill shortages emerge, economic growth may slow to less than 2 per cent by the end of 1996 and little over 1 per cent by mid-1997 - the last possible date for an election. This would mean that unemployment would be rising again.