Inflation: Treasury's forecast highlights gulf between Whitehall and the Bank of England

The danger of an immediate rise in interest rates retreated last night after the Treasury's forecast that inflation would fall over the next 18 months, writes Diane Coyle.

But Adam Cole, UK economist at James Capel, said: "The Treasury's forecast is very questionable. It assumes there will be no spillover from the fall in sterling to domestic prices."

The forecast has highlighted sharp divisions over the outlook for inflation between the Treasury and the Bank of England. Whitehall economists reckon the targeted measure of inflation will have fallen to 2.5 per cent by the end of 1996, while their Threadneedle Street counterparts recently put it a whole percentage point higher by then.

Since the Bank's forecast assumed an unchanged interest rate and exchange rate, the difference casts light on what the Treasury thinks will have altered within the next 18 months. It is likely to have incorporated a rise in base rates and recovery in sterling. City economists thought the prediction must incorporate base rates up to a point higher than their current level of 6.75 per cent.

Many economists see the Treasury forecast as over-optimistic, even though it has been revised up since the Budget. The official prediction for the RPI less mortgage interest payments (RPIX), the target measure, has increased to 3 per cent in the second half of this year, up from the previous forecast of 2.5 per cent. In May actual RPIX inflation reached 2.7 per cent.

The Chancellor of the Exchequer, Kenneth Clarke, said policy would be set all the time with the aim of achieving inflation of 2.5 per cent or less.This is the "inner target" he set out in his recent Mansion House speech.

The outer target range of 1 to 4 per cent was a recognition that unpredictable events would sometimes take inflation above 2.5 per cent.

The Treasury's inflation projections suggest Mr Clarke will not change his view before next week's monthly monetary meeting that there is no urgent need to increase base rates. "The forecast provides him with new ammunition," said Jonathan Loynes at HSBC Markets.