View from City Road: Inflation could still bounce back next year

October's surprise fall in inflation could not have come at a better time. Over the next six months we will see, more or less automatically, a significant upward pressure on both the headline and underlying rates as taxes rise and mortgage cuts drop out of the annual comparison of prices. If the starting point of rising inflation is lower, the end result will be less damage.

The fall last month was largely the result of dogs failing to bark. October usually sees rises in food, petrol, clothing and household goods prices, which this year were conspicuously absent or smaller than usual. This was helped by supermarket competition and nervousness among retailers, who put unaggressive prices on their new autumn ranges.

The effect could unwind by the spring if consumers find the Budget clobbers their finances less than they expected and retailers feel they can get away with more.

But over the same period the annual rise in retail prices will be pushed higher by cuts in mortgage rates a year ago. Between November 1992 and February 1993 lower mortgage rates reduced the retail price index by more than 1 per cent. Mortgage rates would have to fall by the same amount this year if inflation were not to come under upward pressure.

The tax measures announced by Norman Lamont in March - including the imposition of VAT on domestic fuel - will add nearly half a percentage point to prices in April.

These effects mean there is still a danger that inflation could be as high as 4 per cent next year, which may tempt unions and employers to agree significantly higher pay settlements. Anything the Government can do to keep headline inflation under control as taxes bite and the recovery strengthens will help to keep pay settlements subdued.

A full one-point cut in interest rates around Budget time - triggering lower mortgage rates - would do the trick and would offset the depressing impact of tax increases on the recovery.