Chancellor and Governor's clash over interest rates goes public

A significant rift has opened between the Chancellor of the Exchequer and the Governor of the Bank of England over how to manage the economy, it was confirmed yesterday.

Details of their meeting on 5 May reveal that the two clashed over interest rate policy.

Mr Clarke rejected Mr George's firm advice to raise base rates at the beginning of last month, despite a strong warning that this would damage the credibility of monetary policy.

The surprisingly frank minutes, which have finally convinced the financial markets that they are not doctored before publication, introduced the possibility of small, quarter-point increases in base rates as their peak approaches. However, the Chancellor's arguments indicate that even a small increase could be months away.

Publication of the minutes came the day after the influential mid-year forecast from the Organisation for Economic Co-operation and Development said UK base rates might have to rise to 8 per cent to keep the lid on inflationary pressures. On top of this unusually explicit warning from the OECD, Mr Clarke's comments at last month's meeting have convinced the financial markets that he is taking a risk on inflation.

The Governor warned that the persistent weakness of the pound meant inflation would still be in the upper half of its 1-4 per cent target range by the spring of 1997 if base rates stayed at their current level of 6.75 per cent. He pointed out that the economy was still growing above trend, and price pressures were increasing. To leave rates unchanged would ``risk undermining the best prospect of sustained non-inflationary growth for ages.''

Although it was never possible to be sure about the financial market reaction, the Governor said that if interest rates did not go up by half a percentage point, ``the authorities could be faced very quickly with a loss of credibility and a very difficult market situation''. He said the point at which monetary policy had been tightened enough might well be reached during the year, ``but that point had not been reached''.

The Chancellor thought the decision was finely balanced. He rejected Mr George's view about the possible damage to policy credibility, saying his judgement was ``based on a broad assessment of all the economic data, rather than market expectations.''

In particular, the Chancellor argued, the pace of economic growth was clearly slowing to a more sustainable rate, with little sign of inflationary pressure. Mr Clarke said that adjusted for the National Lottery, the annualised rate of growth was 2.8 per cent, and ``it was not clear that such a rate of growth was unsustainable''.

City economists criticised this as a rash view. Bill Martin, chief economist at UBS, said: ``This is an echo of the errors at the end of the 1980s, when policy makers acted in the belief that the economy's trend growth was much higher.''

Since the 5 May meeting, most of the new economic statistics have tended to support the Chancellor, although sterling has not recovered. Mr Martin said the tensions would increase, however, as the inflation rate rose. ``This full and frank exchange will give way to a bare knuckles debate,'' he said.