Pressure on Clarke to cut rates: Surprise fall in manufacturing and rise in inflation hit Budget plans

KENNETH CLARKE faced growing pressure for a further cut in interest rates yesterday as official figures cast doubt on the strength of the recovery by showing that manufacturing output fell in August.

But separate figures showed that inflation rose to a six-month high of 1.8 per cent in September, tempering City hopes that the Chancellor could cut base rates without compromising his inflation target.

Confidential briefing documents prepared for the Chancellor by Treasury economists - and leaked to the Labour Party - showed that the figures were worse than the Government had expected.

The documents also revealed that the Treasury expects inflation to continue rising, and that factory production will almost certainly turn out to have been weaker in the past three months than it bargained for in Budget preparations.

Factory output is sliding more rapidly than at any time since the beginning of last year, when the recession was approaching its trough. Economists believe this makes it more dangerous for the Chancellor to raise taxes again in next month's Budget, as that would take more spending out of the economy.

Although the faltering recovery will fuel pressure from the Tory right on Mr Clarke to attack the deficit through deeper spending cuts rather than tax increases, there were mounting signs last night that Cabinet ministers are unable to agree the cuts to keep spending to the planned pounds 253.6bn.

John Major has stepped into a high-profile conflict between Mr Clarke and Malcolm Rifkind, Secretary of State for Defence, over the Treasury insistence on further cuts in defence spending beyond those agreed under Options for Change.

Mr Major is understood to have convened a meeting with Mr Clarke, Michael Portillo, Chief Secretary to the Treasury, and Mr Rifkind, but without officials. Mr Rifkind is fighting a heavy rearguard action, with strong backbench support, against further cuts. His resistance will be reinforced on Monday by a select committee report arguing that the armed forces are already overstretched.

Mr Rifkind is expected to announce during next week's defence debate that the ministry has abandoned plans for a new tactical air- to-surface missile (Tasm) in favour of a cheaper sub-strategic option, possibly using warheads from Trident submarines. But the Treasury are thought to disapprove of submissions for a bulk ammunition order, providing steady work for Royal Ordnance Factories, and development of the Challenger tank.

According to the Central Statistical Office (CSO), manufacturing production fell by 0.4 per cent in August after seasonal adjustment.

The retrenchment was most spectacular in vehicles, with output of cars down by 7 per cent on the month and commercial vehicles by 30 per cent. Only the engineering machinery and minerals industries raised production significantly.

The Treasury's preferred measure of the trend in output - comparing the past three months with the previous three months - showed a fall of 0.7 per cent. This was the biggest drop since early 1992, although it was exaggerated by the late May bank holiday.

The Treasury said the deterioration reflected weaker spending in European countries mired in recession. But Ian Shepherdson, economist at Midland Bank, said it was a myth that lower foreign demand was entirely to blame.

Mr Shepherdson warned that output throughout the economy - of which manufacturing accounts for less than a quarter - could have fallen in the past three months. He said that some of the unexpected rise in inflation was likely to subside and 'there is still a strong case for lower base rates'.

Underlying inflation - excluding mortgage interest - rose from 3.1 to 3.3 per cent in September. The Bank of England predicted in its August Inflation Report that underlying inflation would be 3 per cent in September. The rise in inflation reflected higher motoring costs and a continued rise in clothing, footwear and household goods prices.

The state pension is normally increased in line with September inflation, implying a pounds 1 a week rise for a single pensioner to pounds 57.10 a week and a pounds 1.60 rise for a couple to pounds 91.40.

But the CSO also published a special inflation index for the goods pensioners are likely to buy, suggesting a 1.8 per cent increase will not maintain their standard of living. The inflation rate for a single pensioner is running at 2.4 per cent and for a couple at 3.2 per cent.

Leading article, page 19

Treasury expectations, page 35

View from City Road, page 36