Inflation fears unfounded

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When Kenneth Clarke made his controversial decision in May to resist Eddie George's call for an increase in interest rates, many thought he had put political considerations before the long-term health of the economy. Yesterday's inflation figures, and signs of a faltering recovery suggest that - whatever his motives - the Chancellor made the right decision.

The headline rate of inflation which had been expected to rise sharply remained unchanged in July at 3.5 per cent. Heavy discounting in the shops indicates that retailers are taking much of the inflationary pressure from manufacturers on the chin rather than trying to pass it on to consumers by jacking up prices.

Another favourable sign is the extremely muted picture of wage inflation that emerged earlier this week. The annual rate of earnings is rising at only 3.5 per cent, a far cry from the familiar story in which earnings outpace retail price inflation.

Any Chancellor has to balance inflation targets with the health of the economy. In May the economy appeared to be bounding along, and there was concern about a build-up of inflationary pressures. At that time calls for higher interest rates appeared justified - but things have changed.

Growth in the economy has visibly slowed over the summer. Unemployment rose by 1,700 in July - the first increase in two years - suggesting that the economy is too weak to take a rise in interest rates. The housing market is flat. Even the upturn in retail sales has turned out to be largely an effect of retailers' desperation to shift stock at any price.

While the Bank warned earlier this month that interest rates should rise, Mr George has already notably toned down the urgency of his call for higher rates. What seems indisputable is that the balance of risks has changed. An increase in interest rates now could tip the economy over a cliff. That risk is much greater now than the danger of an inflationary relapse. So Mr Clarke has good economic grounds to persist in his stance on interest rates.

It is vital, however, that he refuses to yield to the demands of Conservative backbenchers worried about their seats for big tax cuts in his November budget. With the latest figures suggesting that the PSBR will overshoot the target for the financial year 1995-6 by as much as pounds 5bn, there is no leeway for politically motivated tax cuts. Any room for economic manoeuvre should be used to cut interest rates rather than taxes, which would benefit the housing market and boost investment which has continued to disappoint.

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