Decision on rates poses tough test for Bank

The Bank of England this week faces one of its toughest tests since it was handed independence six years ago as it decides whether to back Gordon Brown's optimistic view of the economy and raise its growth forecasts or cut interest rates as the majority of City economists expect.

Its discomfort is increased by the fact that the Bank's decision on interest rates will be seen as a verdict on the Budget.

The Bank's most recent forecast, published in February's inflation report, was for growth to slow to 2 per cent in 2004 and 2005 – in contrast to the Chancellor's expectation of growth of 3 and 3.5 per cent.

However, Mr Brown gave a strong hint last week that he expected the Bank to raise its forecasts when he described the February figures as "out of date".

There is intense political speculation that the Treasury has pencilled in higher growth in order to fill a £10bn "black hole" in the public finances.

The Bank must either back the Treasury's view by raising its forecasts and risk losing some credibility as an independent central bank or highlight the split between the fiscal and monetary authorities.

A poll conducted between last Tuesday and Thursday showed 24 out of 32 economists forecast the Bank would cut rates by a quarter-point to a fresh 48-year low of 3.5 per cent.

Economic data over the past month has been mixed. Manufacturing industry is on a rebound, retail sales were strong in March and April and consumers are still borrowing to fund their spending. But GDP growth is at a 10-year low and house prices are falling according to some surveys. "May's rate decision is about as close as it gets," said Geoffrey Dicks at Royal Bank of Scotland.

Stephen Lewis, the chief economist at Monument Securities in the City, said he expected the Bank to "edge up" its forecasts – a move that would prevent a rate cut.

"That is the most attractive route and would let them off the hook although its forecasts are still bound to be compared with those the Treasury," he said.

"The chief danger when monetary policy marches to a different drumbeat from fiscal policy is that the results turn out to be ill-suited to the economy's needs."

Another key factor will be the inflationary impact of the fall in the pound, which last week slumped to a four-year low just short of 70p to the euro. It has fallen 5 per cent against Britain's main trading partners since February and last month the Bank said this could add between 0.5 and 1 per cent to inflation.

Philip Shaw, the chief UK economist at Investec who changed his forecast last week from a cut to no change, said this was the main reason.

Other economists believe these concerns will be overriden by worries that only a cut in rates will avert an impending slump in consumer spending.

Richard Iley at the investment bank ABN Amro said: "A decisive move on rates, as seen in the aftermath of the terrorist attacks on the US, could have a rapid impact on both consumer and business confidence. This would both delay and mitigate the required adjustment by the household sector and sustain the economy's tightrope act."

Analysts on the other side of the Atlantic face an equally nail-biting time on Tuesday evening when the US Federal Reserve sets interest rates.

A swath of bad US economic data last week has also put a rate cut by the Federal Reserve on Tuesday firmly on the table although several analysts said the Fed would simply opt for a change in its bias. The European Central Bank is expected to leave rates on hold on Thursday.