King sets the scene for early rise in interest rates

Pound surges on Governor's comments; OECD also backs rate rise; FSA highlights credit risk

Mervyn King, the Governor of the Bank of England, appeared to pave the way for a rise in interest rates yesterday, saying the new inflation target would not prevent an increase.

The pound surged as traders interpreted it as a green light for a rise in borrowing costs as soon as next month.

There was separate support for a rate rise from the Organisation for Economic Co-operation and Development (OECD), which said rates should rise to head off the risk of a crash in house prices.

Mr King used a keynote speech to scotch fears that the recent change from the retail price index (RPI) to the European-style consumer prices index (CPI) would tie the hands of the monetary policy committee.

"The switch to a new CPI target has in itself no implications for monetary policy," he told a business audience in Birmingham. He admitted the shift from a target of 2.5 per cent under RPI to 2 per cent under CPI had "given the impression" inflation had moved from above to below target.

"Does this mean that monetary policy in the coming months will need to be looser under the new target than it was with the old target? The answer is no," he said.

Official figures yesterday showed CPI was unchanged in December at 1.3 per cent, while RPIX rose to 2.6 per cent.

Mr King said the MPC would continue to monitor house prices to "assess the implications for inflation resulting from changes in the balance between nominal demand and supply and in the exchange rate". He warned it would be on the alert for signs that pay deals were being set in line with the old 2.5 per cent target that might "threaten the target in future".

Sterling soared 2 per cent against the dollar to just short of $1.82 yesterday after Mr King's comments. Michael Saunders, an economist at Citibank, said: "Unless there are clear signs that the recovery is stalling ... we suspect the MPC will hike 0.25 per cent in February."

The OECD warned yesterday that cuts in interest rates - currently at a 48-year low - had triggered a "surge" in house prices which raised the risk of an "abrupt" drop. "Gradually raising rates further would reduce the risk of a larger and more abrupt tightening later on, and hence reduce the risk of triggering instability in the housing market and the wider economy," it said.

But the OECD attacked the Government's public spending as excessive and not necessarily likely to yield improved services. "The jury is still out on whether the massive spending increases will fully pay off in terms of improved service," the Paris-based organisation said. It also warned that Gordon Brown would have to raise taxes to meet his fiscal rules.

The Conservatives seized on the report. Oliver Letwin, the shadow Chancellor, said: "The message is clear - either slow down spending growth or increase taxes."

A spokeswoman for the Treasury said: "Our spending plans remain affordable and consistent with the fiscal rules."

Separately, MPs on the Treasury Select Committee warned that Mr Brown's "golden rule" could be under threat unless tax revenues picked up. "There is now less slack and the Government ... will meet the golden rule only if its central forecasts for economic growth, tax revenues, spending and the likely end of the current cycle are met," it said.

The inflation figures also showed the tax burden on households had hit an eight-year high in the wake of the increase in National Insurance payments. The amount of income before tax needed to buy a typical basket of goods and services rose by 3.6 per cent, the fastest rate since 1995, the Office for National Statistics said.