Nick Clegg is threatening to veto a controversial Treasury plan to freeze pensions and state benefits next April.
George Osborne, the Chancellor, is considering whether to break the Government's pledge to raise benefits in line with inflation in order to save up to £10bn. But the move has provoked a rift with the Liberal Democrats, who are arguing that the most vulnerable people in society should not bear the brunt of efforts to reduce the deficit.
Mr Osborne, who will announce his decision on 29 November, has a dilemma because inflation is rising faster than earnings. The Government's policy is to increase most benefits each April in line with the consumer prices index (CPI) the previous September – 5.2 per cent this year.
It has also pledged to raise the basic state pension by whichever is the higher of three figures – 2.5 per cent, the rise in average earnings (currently 2.5 per cent) or the CPI. The Liberal Democrats have trumpeted this "triple lock" on pensions as a major "win" inside the Coalition because it featured in their election manifesto last year.
Mr Clegg will demand that Mr Osborne's decision be approved by "the quad" – the powerful group which resolves difficult issues that threaten to divide the Coalition parties. Its members are David Cameron, Danny Alexander, the Liberal Democrat Chief Treasury Secretary, Mr Osborne and Mr Clegg.
Liberal Democrat ministers are describing a benefits freeze as a "red line" they would not cross. The Liberal Democrat pressure may force the Chancellor to opt for a less painful squeeze on pensions and other benefits. Treasury officials are also looking at whether they could be raised in line with earnings, which could save about £5bn, or a six rather than 12-month inflation figure, which could reduce the bill by £1.4bn.
Senior Liberal Democrats do not rule out paring back the scheduled 5.2 per cent increase. But they may press for a selective rather than an across-the-board approach which protects the sick and disabled, those recently out of work and pensioners. Insiders expect a compromise to be reached by "the quad".
Mr Osborne could also face opposition from Iain Duncan Smith, the Work and Pensions Secretary, who would have to implement the squeeze and is said to share some of the Liberal Democrats' concerns about hitting the vulnerable at a time when their bills for food, gas and electricity are rising sharply.
The Chancellor wants to maintain the downward pressure on the social security budget.
His allies believe voters would understand the need for restraint on the grounds that the higher-than-expected inflation figure is a one-off. However, opponents will point out that the move could set a dangerous precedent.
Yesterday Downing Street dismissed the idea that benefits might not be fully indexed as "rumour and speculation".Reuse content