Inflation fears set Bank on course for clash with Clarke

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The Bank of England's Inflation Report published on Wednesday will set the scene for clashes between Chancellor Kenneth Clarke and Eddie George, Governor of the Bank of England, in the run-up to a spring general election.

The quarterly report is expected to say that the risk of above-target inflation by mid-1998 could require an increase in base rates sometime during the next 12 months if the economy continues to build up steam.

In its last report in May, the Bank issued a forthright warning that the economy was at precisely the stage at which "policy mistakes tended to be made in the past". Mr George opposed the subsequent month's quarter- point cut in the level of base rates.

A growing number of independent economists are lining up with the Bank's cautious stance. A clutch of new forecasts published today predict that the economy is picking up fast enough to put upward pressure on inflation and interest rates.

According to David Mackie, UK economist at the investment bank JP Morgan, "We are in for the sort of mini-boom which is likely to make the Governor very, very nervous about the inflation target. We could be seeing fireworks by January."

His new report compares the state of the economy with the same point in the Maudling, Barber and Lawson booms. Although the economy has had less stimulus from interest rate cuts in the 1990s, the Government's fiscal policy has been much looser. The parallel suggests the UK is poised for a substantial upturn.

Another investment bank, Deutsche Morgan Grenfell, predicts that unemployment will fall below 7 per cent next year. "The Chancellor believes this is compatible with sustained low inflation - we do not," writes economist James Barty.

Barclays Bank's chief economist, Alan Davies, predicts that base rates will have to climb from their current 5.75 per cent level to 7.5 per cent next year. "Sustaining low inflation will require cautious policies," he says.

Marian Bell at the Royal Bank of Scotland said yesterday: "There is no reason for the Bank of England to have changed its view since May." Although the short-term prospects for inflation are very favourable, the upturn in manufacturing, strong retail sales and sterling's decline from its level two months ago would all concern the Bank's economists, she said.

An article to be published in the Bank's Quarterly Bulletin on Wednesday assesses how quickly changes in interest rates affect different sectors of the economy. It confirms that the biggest and fastest reaction occurs in construction and sectors linked to the housing market.

The research found that a fall of just over 1 percentage point in interest rates would lead to a rise in manufacturing output of nearly 2 per cent after just over two years, with a bigger reaction in construction and related industries.

There is clear evidence that these parts of the economy are responding to the four reductions in interest rates since December. Today's edition of Roof, Shelter's housing magazine, predicts that the housing market is poised for a boom that could need to be dampened, although probably not before the election.

"Whoever wins the election may well face a housing market working its old inflationary magic," it says.

Mr Barty agrees: "If the market continues to recover with the same momentum the Government will have to act at some time next year." Figures from both Halifax and Nationwide building societies last week confirmed that house prices are climbing at an average annualised rate of 5-10 per cent.