Hawkish Bank seeks rate rise to cut inflation

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The Bank of England yesterday delivered a clear warning that interest rates must rise again if the Government wants to hit its inflation target.

By sending a clear signal that it thinks the credibility of the Government's economic policy is at stake, the Bank has thrown down the gauntlet to Kenneth Clarke ahead of the election. The Chancellor is likely to be keen to avoid further base rate increases.

The Bank's quarterly Inflation Report said the short-term outlook for inflation had worsened and the target measure was likely to climb above 3 per cent during the next month or two. It also predicted that inflation was more likely than not to be above the 2.5 per cent target both by May, the latest possible election date, and two years ahead.

The hawkish tone of the report sent the pound and gilts lower. By the end of the day the money markets were betting on base rates increasing half a point by March.

Mervyn King, the Bank's chief economist, said: "Inflation is above the target rate at a time when activity is accelerating. Achievement of the inflation target remains elusive."

The report also warned: "A further rise in inflation in the next month or two could pose questions about the credibility of the commitment to the inflation target."

Last week's surprise rise in the cost of borrowing had helped, but it concluded: "What matters most is the continuous pursuit of a monetary policy which is consistent with achieving the target in the medium term."

Mr King said interest rates would therefore have to rise, although he would not prejudge when and by how much. But he said: "The later you leave it, the more you have to do."

The City drew the conclusion that Eddie George, the Bank's Governor, would push for another interest rate rise at one of his next monthly meetings with the Chancellor. But many thought Mr Clarke would reject the advice. "He has managed to resist the pressure many times before when the political dimension to the debate was not quite so important," said Andrew Cates, an economist at UBS.

Mr King would not be drawn on what advice the Bank had given the Chancellor about this month's Budget. But he indicated it would not approve of measures which stimulated consumer spending. "What we are concerned about is not any specific measures, but the overall balance and how that balance would impact on consumption," he said.

The buoyant growth in demand during the months since August's Inflation Report explains the tougher tone of the Bank's advice this time around. Mr King said the 9 per cent rise in the value of the pound since August had made the assessment of the inflation outlook "unusually difficult".

However, he said monetary policy should not be loosened because of the strength of the pound, despite concerns that this would hit exports and make the recovery unbalanced. "What you should not do is run an easier monetary policy in the hope that the growth in domestic demand will go away."

The report, pointing out that the UK has had the sixth-worst inflation record among the G7 countries during the 1990s, focused on the pick-up in the domestic economy. Domestic demand grew at an annual rate of 4 per cent in the first half of this year, the fastest rate since the second half of 1988, and is accelerating further.

The Bank predicted a faster pace of consumer spending, boosted by building society flotations and takeovers and money from maturing Tessa accounts. It also noted that surveys pointed to higher growth in private investment spending.

Reports from the Bank's agents around the country suggested that manufacturers did not think their current levels of stocks were excessive.

The tighter labour market is another factor behind the Bank's assessment. Mr King said pay increases had climbed a percentage point in the past year. Unemployment on the internationally accepted definition had fallen significantly.

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