UK may adopt Euro-inflation rules

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THE GOVERNMENT is considering setting a new euro-inflation target for the Bank of England as a step on the way towards joining the single currency. A switch to the harmonised measure of inflation would pave the way for big cuts in British interest rates.

The new target, under active discussion in the Treasury, would be based on the harmonised price measure used by members of the European single currency. It would replace the existing target for UK retail price inflation. Although no decision has yet been taken, the move could be announced in the March Budget, when Gordon Brown has to confirm the inflation target. Alternatively, the Chancellor could introduce a target either in the national changeover plan for Britain's possible entry into the euro, due to be published later this month, or in his annual Mansion House speech.

Adopting the same inflation target as the euro members is seen as an essential part of the preparation for eventual UK entry by Treasury officials. But the decision will also be taken as a clear signal of the Government's intention to join, making its timing sensitive.

If the euro-inflation measure is adopted, it would add to the pressure on the Bank of England to cut interest rates. UK inflation as measured by the "harmonised index of consumer prices" is just 1.4 per cent, well below the 2 per cent inflation target adopted by the European Central Bank (ECB).

The ECB has set a target which requires inflation on the harmonised measure to be below 2 per cent. The Government has set the Bank of England a target of 2.5 per cent for retail price inflation excluding mortgage interest payments, known as the RPIX, with up to 1 per cent deviation either way.

The harmonised price index was created after the Maastricht treaty so that European Union countries would have a directly comparable measure of inflation.

It is similar to the RPIX but includes goods such as computers whose price has been falling sharply, and is therefore lower.

The latest UK figures for inflation put the annual increase in the RPIX at 2.5 per cent, or just on target, in November, whereas the euro-inflation measure stood at just 1.4 per cent for the UK, or well below target. Interest rates in Britain are more than double the Euroland level, currently 3 per cent.

Even if the Bank does decide to cut rates from 6.25 per cent when the monthly meeting of its Monetary Policy Committee ends at noon today, the gap between the cost of loans in Britain and across the Channel will remain unusually large.

Hopes of the fourth reduction in the cost of loans in as many months sent share prices in London soaring yesterday. The FTSE-100 index jumped 191 points to 6,148.8, within a whisker of its July record of 6,179.

Many City experts believe the economy is weak enough for inflation to be no danger. Even so, switching targets could still pose the presentational problem of convincing the financial markets that the Government was not turning softer on inflation because it fears a recession.

The Bank of England has come under intense pressure from both sides of industry to cut interest rates further and faster. The Trades Union Congress weighed in yesterday with a call for a full percentage point reduction in rates today.

Separately, a survey of the service sector suggested that business has slowed so much that firms in the most buoyant part of the economy have started to axe jobs.

Only the computer industry is continuing to expand vigorously.