Honeymoon period for Brown and Bank may be over

Divergence of views over growth may be reflected in tomorrow's interest rate decision

Gordon Brown's decision six years ago this week to hand over the job of interest rates to the Bank of England is still seen as one of New Labour's most successful political gambits.

The Bank has, on balance, earned widespread praise for its operation of an independent monetary policy in the face of the Asian and Russian financial crises, an oil price shock, a US recession and the 11 September terrorist attacks.

Meanwhile, the Chancellor has broadly escaped the flak that controversial interest rate decisions attract.

But at the time the Bank won independence, economists with an eye on the historical precedents warned that the real tests of the new arrangements still lay ahead. They may now be vindicated.

The challenge comes not from abroad but domestically, from right at the heart of Government.

When the Bank finalises its latest inflation forecast and sets interest rates this week, it does so against the background of a highly optimistic view being taken at the Treasury.

According to its February report, the Bank expects economic growth to slow to 2 per cent in 2004 and 2005 – the same two years that Mr Brown expects to see growth of between 3 and 3.5 per cent.

This leaves the Bank with a lose-lose situation. If it raises its forecasts, it will be criticised for being seen to kowtow to the Government. If it does not, then it will be used by opposition political parties as a rod to beat the Government for being over-optimistic.

Either outcome could create tension between the Chancellor and Mervyn King, who has been appointed by Mr Brown to take over as Governor of the Bank on 1 July.

"If the Bank were to fall in line with the Treasury on growth, the wisdom of February's rate-cutting action might, in retrospect, appear suspect," Stephen Lewis, the chief economist at Monument Securities, said.

"If, by contrast, the Bank sticks to its guns and comes up with a growth forecast as downbeat as in February, if not more so, it could prompt headlines adverting to a Bank versus Treasury split."

If there were to be a long-term split between the monetary and fiscal authorities it would be nothing new. It was a familiar feature of the operation of German policy.

This persists in the running of the European single currency zone, where the European Central Bank continually berates the governments of member states for failing to control their fiscal deficits.

The Government has made no secret that it expects the Bank to fall in line with its own forecasts. Last week the Chancellor told MPs that attempts to identify a split were based on "out of date forecasts".

"If you want to hang your whole case on a forecast that was made before the Iraqi war, when the oil price was incredibly volatile and wasn't coming down, when there was a huge amount of additional uncertainty, that is a matter for you," he told one Tory MP.

"But I would suggest to you that you should wait until the Bank of England publishes its latest Inflation Report in May."

Aside from political sparring, the serious impact will be on monetary policy itself. The Bank's current forecasts would support another rate cut, while the Treasury's forecasts would rule that option out and – with growth above trend for two years – the Bank might be considering a rate rise.

Robert Barrie, UK economist at Credit Suisse First Boston bank, said he believed the Bank should raise its own forecasts. "They looked a bit odd at the time," he said.

On top of the factors cited by the Chancellor, the 5 per cent depreciation in sterling's exchange rate would justify pushing up the forecasts for both growth and inflation.

Mr Barrie said he expected the Bank's new figures would still come in lower than the Treasury's forecasts. "I think that the monetary authority needs to be independent and it must take its own view," he said.

"Right or wrong it must decide on its outlook for growth and set interest rates accordingly. They must stand or fall on their forecasting record as they have done in the past."

One of the ironies is that a decision to cut rates justified by the Bank's forecasts would certainly help Mr Brown's predictions become reality.

For Mr Barrie the more serious issue is forecasting the state of the public finances. Mr Brown was criticised after publishing a Budget showing a deficit of £27bn in the current financial year, shrinking to £24bn and £23bn in the following two years.

The average of the latest City forecasts point to a shortfall of £29bn this year followed by a deficit of £31bn.

This would further restrict the room for rate cuts, Mr Barrie said. "Other things being equal, a more expansionary fiscal policy means a less accommodative monetary policy," he said.

David Smith, the chief economist at Williams de Broe stockbrokers, said the Bank must be aware of the adverse effect that tax-on-spend policies would have on the economy's overall supply capacity.

"This means the MPC needs to pursue a tighter monetary policy for any given inflation target than would otherwise have been the case," he said.

Mr Barrie said the Bank should be more open and independent on its analysis of the public finances. "I think the time has come for the Bank to take a view on the public finances and not rely on the Treasury's view, which has been the practice up to now," he said.

Such dramatic manifestation of independence would come at a time when the Bank faces a drastic shake-up in its leadership.

Sir Edward George, the current Governor, retires on 30 June, to be succeeded by his deputy, Mervyn King. Mr King's job will be taken by Rachel Lomax, a former permanent secretary at three Whitehall departments.

The other deputy governor, Sir Andrew Large, joined from Barclays Bank only last October. Richard Lambert, a former journalist, is to join the MPC as an external member in June.

All of these appointments are made by, or in consultation with, the Chancellor of the Exchequer. This process, and the secrecy around it, has been criticised by opposition politicians and by a non-partisan House of Lord committee.

Christopher Huhne, the Liberal Democrats' European economics spokesman, frequently points out that this factor makes the Bank of England less independent than, say the European Central Bank.

Although Mr King does not take over as Governor until July, he will have the job of maintaining the reality and perception of independence.

The first six years of Bank of England independence have included a period of benign inflation, strong growth and huge public finances surpluses.

All these trends appear to have come to an end and if economic growth stutters and unemployment rises, the Government may be tempted to blame the Bank of England for its ills.

Will the Treasury view prevail?

Gordon Brown
The Chancellor has gambled on economic growth of between 3 and 3.5 per cent in 2004 and 2005 to justify his very ambitious forecasts for tax receipts

Mervyn King
The Governor-elect will either have to justify moving growth forecasts closer to the Treasury's figures or be quizzed on whether there is a split between the two