Outlook: Why the hiccup could help cut rates

ARE INTEREST rates much too high? The TUC thinks so, calling for a 1 per cent cut from the Monetary Policy Committee today and another 1 per cent by the summer. Most of industry would go along with this. The economy is slowing rapidly, there are no inflationary dangers on the horizon, and the pound is still too high for comfort.

What's more, the euro-friendly policies of our Labour Government point towards much lower interest rates too. Euro interest rates are only half the level of UK rates and likely to be cut further soon because of ominous signs that the big continental economies are slowing again. Reducing the differential between UK and euro rates, along with the need to get the pound to a more comfortable level, is a key part of preparing the British economy for joining the single currency.

So it would seem to make sense to adopt a new inflation target based on the harmonised index of consumer prices (pleasingly known in the City as "the hiccup"). Not only would this symbolise Britain's honourable intentions towards the euro, it would also allow more room for interest-rate cuts without risking the inflation target.

As things stand, the policy framework wouldn't allow a rapid convergence of short-term interest rates with Euroland, even though economic conditions could scarcely be more conducive to it than they are now. The straitjacket of the Government's inflation target, as defined by the retail price index, makes any such leap impossible. However, if the target is redefined using the hiccup, then it becomes much easier.

The UK's "harmonised" inflation rate is only 1.4 per cent, well below the 2 per cent ceiling adopted by the European Central Bank as equivalent to price stability. A switch from a 2.5 per cent RPIX target to a 2 per cent target for the harmonised index would obviously allow for a quite significant loosening of policy.

Politically, that is bound to be seen as something of a climbdown for the Chancellor, tantamount to admitting that he has allowed the newly independent Bank of England to be too tough on the economy to date. He's therefore going to think long and hard before going this route. On the other hand, Wim Duisenberg and his ECB colleagues can hardly be seen as the sort of people who play fast and loose with inflation. If the Government is going to do it at all, now's the time.