The reaction of small businesses, mortgage lenders and housebuilders to the Chancellor's decision was summed up by John Wriglesworth, head of strategy at the Bradford & Bingley building society: ''The housing market needed this like a hole in the head.''
Mortgage interest rates are now about 8.1 per cent. If lenders impose a full half-point rise, monthly payments on a typical pounds 50,000 loan would jump by pounds 20. But lenders are reluctant to raise rates because they fear a collapse in the already fragile housing market.
City economists warned that if today's mini-budget package of measures to make up for the lost VAT revenue is unsatisfactory, the cost of borrowing would have to rise again.
Mr Clarke said: ''I have decided to increase interest rates by 1/2 per cent, in order to sustain economic recovery with low inflation.'' Many independent forecasters thought that the danger of higher inflation meant the next rise could be needed as early as next month.
Howard Davies, director-general of the Confederation of British Industry, said Mr Clarke must restore confidence in fiscal strategy: ''Continued uncertainty could prove damaging and would increase the risk of further, premature interest rate rises.''
Yesterday's prompt interest rate response to the Government's VAT defeat was well received in the financial markets. One reason is that the abandoned increase in VAT on household heating and fuel means the inflation rate next April will be closer to 2 per cent than the 2.5 per cent forecast in the Budget.
The case for the rate rise, which follows a 1/2 per cent increase in September, was made in the Treasury's monthly Monetary Report, presented to the Chancellor and the Governor of the Bank of England, Eddie George, at their policy meeting yesterday morning. It spelt out the evidence that the economy is growing too fast, bringing the risk of higher prices. The evidence was reinforced by figures published yesterday showing that manufacturing output rose 5.5 per cent in the year to October.
Yet the recovery is unusually weighted towards exports and industry. Consumers, retailers and small businesses are not sharing the fruits of the economic success.
Richard Brown, the deputy director general of the British Chambers of Commerce, said: ''We cannot welcome this rise in interest rates at a time when retailers - particularly small ones - continue to struggle in the face of consumer wariness.'' Bernard Juby, of the Federation of Small Businesses, representing the UK's smallest firms, said: ''I accept low inflation is good for the economy, but what is the point for small firms when they are being driven out of business?''
How the Chancellor could raise the shortfall
- Cancel new transitional relief on business rates pounds 605m
- Increase corporation tax by 1 per cent pounds 480m
- Abolish capital gains tax relief on house sales pounds 850m
- 1/2 p on basic tax rate pounds 850m
- Miras restricted to 10p in pounds pounds 900m
- 10 per cent off personal allowances pounds 1,850m
- Inheritance tax on transfers to spouse pounds 900m
- 2.5p extra duty per litre of petrol pounds 855m
- Extra 20p on 20 cigarettes pounds 790m
- Increase VAT rate to 18 per cent pounds 1290m
- VAT on newspapers, books, magazines pounds 1,050m
- VAT on prescriptions and clothes for children pounds 1bn