View from City Road: Budget will change interest rate outlook

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The Independent Online
The temptation is to see the Bank of England's assessment of the prospects for inflation as a warning against another cut in interest rates. After all, the Bank's economists are a little gloomier today than they were in August about the immediate outlook, and they think there is a serious possibility that inflation (excluding mortgage rates) will exceed the top of the Government's 1-4 per cent target range in the first half of next year.

Given that the Bank also thinks the Government is unlikely to push inflation into the lower part of its target range on current poli cies, surely Kenneth Clarke cannot be about to shave interest rates? And then there were the warnings from the Governor about interest rates on Friday, apparently sanctified by the Chancellor in his television interview on Sunday.

Nevertheless, the money markets' expectation continues to be for a small cut in interest rates sooner rather than later, and the markets are probably right. It is not hard to construct a thoroughly sensible case for the Chancellor to cut interest rates precisely because of the dim short-term outlook for inflation.

If that sounds too contrarian, consider that one of the threats to the inflation outlook is the artificial hump in the 'headline' inflation rate in the new year. This arises as the mortgage rate cuts earlier this year drop out of the annual comparison, and it is likely to take the headline rate near to if not over 4 per cent. However, another cut in mortgage rates might well keep the rate below target.

Nor would this necessarily be an irresponsible reaction to the problem. After all, if wage bargainers take the rise in the headline rate as the basis for their pay deals, settlements could begin to ratchet upwards at an alarming rate.

And that rise in pay could embed what would otherwise be a temporary increase in the inflation rate into the labour market psyche. An artificial hump could become much longer lasting.

It is therefore arguably in the Chancellor's interest to offset any such risk by cutting mortgage rates again. However, the quid pro quo would have to be public spending cuts or tax increases: a cut in interest rates is only anti-inflationary in the very short term because of the bizarre inclusion of our mortgage interest rates in the retail price index.

If the medium-term outlook for inflation is not to deteriorate, there must be an equivalent tightening of other aspects of economic policy.

We now know that cuts in the overall level of public spending are off the agenda since the Government has confirmed the control total on which it settled in the summer, which leaves tax increases. But here the Chancellor faces a snag.

A rise in indirect taxes such as excise duties on tobacco or spirits or an extension of Value Added Tax to items like food or newspapers would push up the retail price index.

So there is little point in attempting to smooth the hump of the headline rate by means of interest rate cuts if the price of the manoeuvre is roughing it up again with VAT rises.

The answer to the Chancellor's conundrum is surely to elect for direct tax increases - a little on company taxes, a cut in income tax allowances, maybe even a trim for mortgage tax relief, or something more radical if Mr Clarke feels like indulging in a healthy diet of his own and his predecessors' words. Non-inflationary fiscal tightening combined with anti-inflationary interest rate cuts could work wonders.

It would also be the mixture that would probably be most welcome in the financial markets, precisely because both the gilts market and the stock market have been driven not just by lower interest rates but by the prospect that they would stay low because inflation would stay low.

And what of all those weekend warnings designed to damp down expectations of an interest rate cut? When Eddie George, the Governor of the Bank, said on Friday that interest rates were at the right level, he was careful to add 'as of now' while carefully scrutinising his watch. As of the budget, it may be an altogether different matter.