Debt control holds the key to continued stability

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The Chancellor gambled that households would rein in their spending plans fast enough to keep interest and mortgage rates on hold until the next general election.

The Chancellor gambled that households would rein in their spending plans fast enough to keep interest and mortgage rates on hold until the next general election.

In his pre-Budget report (PBR) Gordon Brown forecast that economic growth would slow next year, as it must do if the Bank of England is to keep its hand off the trigger of the interest-rate gun.

"Our choice is to lock in the stability by prudently cutting debt and debt interest payments to keep inflation and interest rates low," he told a packed House of Commons.

The PBR showed GDP growth slowing from 3 per cent this year to between 2.25 and 2.75 per cent in each of the next three years. This is unchanged from the March Budget.

It also brings growth down to the 2.5 per cent level using a mid-point of the forecast range and the Government believes the economy can grow without triggering inflation

Unsurprisingly, inflation is forecast to meet the Government's official target of 2.5 per cent next year and stay there until at least 2003. The key to this positive outlook for growth and inflation is the output gap - the difference between the actual output and trend output measured as a percentage of trend output.

A year ago this was estimated to be 0.25 per cent, but the figure was revised to 0.5 per cent in the March Budget, with a warning attached that the economy could "not afford to out-run its trend growth rate in future years".

The Government now estimates the output gap to be at "around 0.5 per cent".

The Chancellor continued: "Strong output growth can be accommodated for a period. However, as the Monetary Policy Committee has made clear, it is important that growth in aggregate demand does not outpace potential output growth for long."

The main force behind the slowdown is household spending, which was rising by 4.25 per cent in 1999. It is forecast to slow to between 2.25 and 2.5 per cent in 2001 and then to between 1.75 and 2.25 per cent in 2002 before climbing back.

In contrast, government spending will accelerate sharply from 2.25 per cent this year to 4 per cent for each of the following two years and 3.5 per cent in 2003. The Treasury is more cautious than independent forecasters. The average forecast from 29 economists shows growth hitting 3 per cent for this year but slowing to 2.7 per cent next year. They believe private consumption will slow only to 2.8 per cent.

Philip Shaw, UK economist at Investec in London, said: "It is a very benign economic scenario, with domestic demand moderating and an output gap that is positive but moving towards zero."

He said that while the overall picture supported the Chancellor's stated aim of lowering interest rates, the greatest threat was from the public finances. "They tend to support our view that rates will have to rise at some point," he said.

The Government is also relying on the continuation of a benign labour market, with unemployment falling without triggering a surge in inflation.

For the first time it gave a figure for the sustainable rate of unemployment. It said this had fallen from 7 per cent three years ago to 5.5 per cent now - only just above the current level of 5.3 per cent.

The most significant change between the Budget and the PBR was in the outlook for the UK's trade position. Exports are now expected to rise 8 per cent this year and by 7 to 7.25 per cent in 2001 before slowing to around 6 per cent in 2002 and 2003. These forecasts are as much as 2 percentage points higher than in March.

As a result, the balance of payments deficit comes at £14.5bn and £15bn for this year and next - £5bn better than in the March Budget.

A Treasury spokesman said this was based on a positive outlook for world demand. "The risks are well known," he said.

Nick Stamenkovic, a senior European analyst at Nomura International, said: "I am a little bit concerned about the global picture. The export growth may be difficult to achieve."

Fraser Coutts, an independent analyst, said there was little sign of a rebalancing in the economy between strong consumer and government spending and weak business investment and a current account deficit.

He said that despite the Chancellor's claim that business investment was solid, it was forecast to fall over the PBR period. "The economy is still unbalanced and this could be an inflation risk," he said.

The Bank of England will decide today whether it should keep interest rates on hold at 6 per cent, as it has done since they were was last raised in February.

After it tightened the cycle nine months ago, the expectation was that rates would eventually have to rise again to tackle strong house-price inflation, strong growth in private-sector demand and a tight labour market.

Recently, however, the prospect of a peak in interest rates has emerged.