Breaking golden rule will damage Government, says Bank

The Government should raise taxes or slash spending to avoid a "very damaging" loss of credibility if it broke its rules on balancing the budget, the Governor of the Bank of England warned yesterday.

The Government should raise taxes or slash spending to avoid a "very damaging" loss of credibility if it broke its rules on balancing the budget, the Governor of the Bank of England warned yesterday.

In an outspoken intervention in the highly charged debate over the Budget forecasts, Mervyn King said the Government had "put itself on the line" over its economic forecasts. In wide-ranging testi-mony to the Commons treasury select committee, he welcomed figures in last week's Budget showing the deficit would fall from £37bn to £23bn by 2009.

"I draw comfort from the fact that we have a clear set of fiscal rules because if it turns out that [tax] revenues are not rising as expected the Chancellor will have a choice between failing to meet his fiscal rules ­ which would be very damaging for credibility of fiscal policy ­ or making adjustments to spending or taxes," he said. "There's a very clear framework and the Treasury has put itself on the line by saying these are the rules by which we are to be judged."

The main rule Chancellor Gordon Brown put in place in 1997 says that over the cycle the Government should not borrow to fund current spending.

Mr King declined to say whether he thought the rule would be broken but his comments come just days after leading independent economists said he would have to find £10bn in tax rises to close a gap. On Wednesday Mr Brown told MPs he would stay within the rule, saying his spending plans were "affordable and fully funded".

In a sign of growing tensions between the Bank and the Treasury, Mr King repeated his criticism of Ed Balls, Mr Brown's chief economic adviser, for making speeches on monetary policy just days before interest rate decisions. In a speech two days before the MPC raised rates on 5 February, Mr Balls said there was "now a consensus" across the country for a "pre-emptive" approach to monetary policy.

Yesterday Mr King said: "These comments can be misinterpreted and that's why we [at the Bank] stick to the purdah system."

He told MPs the Bank had a different estimate of the output gap ­ how far above or below trend the economy is running ­ than the Treasury. He said the main difference was the measurement of public sector activity, saying the Bank was worried about the "quite high magnitude" of public sector inflation.

"Prices look high but real growth looks low," he said. "We are trying to gauge the pressure on resources as a whole. People employed by the public sector are not available to the private sector."

The pound tumbled after Mr King said the exchange rate was "making life difficult" for exporters. "The effective exchange rate is now about 6 per cent higher than when we last met with the Committee [in November] and is continuing to make life difficult for many exporters," he said.

Mr King and three other members of the MPC played down the need for early rate rises to burst a house price bubble, saying they had no plans for surprise rate increases to "jolt" consumers. The markets seized on Mr King's comments on consumer debt to sell the pound, saying that made an April rate rise less likely. The pound tumbled 1 per cent against the euro and 1.5 cents against the dollar.

Mr King and fellow MPC members Kate Barker, Marian Bell and Rachel Lomax said the Bank was being deliberately cautious because of an uncertainty over how rising rates would affect debt-laden households. Ms Barker said: "I think that jolting the consumer may be a rather dangerous tactic."

Nick Stamenkovic, an economist at Edinburgh bond broker RIA, said: "I got the impression there is no urgency to raise rates. They are upbeat about the economy but there did not seem to be a smoking gun to raise rates as soon as April."