New inflation target eases rates pressure

The new inflation target announced by Gordon Brown, Chancellor of the Exchequer, in his first Mansion House speech last night was seen as reducing the pressure for further interest rate increases this summer.

The Chancellor set a new target for inflation of 2.5 per cent, and said the Governor of the Bank of England would have to send an open letter of explanation whenever inflation rose above 3.5 per cent or fell below 1.5 per cent. "I have tightened up the framework. I have made it more rigorous and I have made it more open," he said yesterday.

However, most City economists thought the new target was not as tough as the previous "2.5 per cent or less".

"It is a slight dilution of the existing position. I'm a bit disappointed," said Geoffrey Dicks, chief UK economist at NatWest Markets.

"The Bank of England used to see 2.5 per cent as an upper limit and were aiming for something less. This is a looser target," said Jonathan Loynes at HSBC Markets.

He welcomed this, however, saying: "There was a need for a check on an independent Bank of England to prevent it from overkill on interest rates."

Eddie George, Governor of the Bank of England, warmly greeted the new remit set by the Chancellor and his decision to give the Bank its independence to set interest rates. He said it demonstrated as clearly as anything could Mr Brown's commitment to stability and long-termism in the British economy.

The Governor indicated that the Bank was pleased to have a range of variability in inflation before it would need to formally account to the Chancellor for missing the 2.5 per cent target.

"I welcome the Chancellor's detailed reformulation of our marching orders, which acknowledges the volatility of the real world," he said.

The speeches came as new figures yesterday showed that the target measure of inflation, which excludes mortgage interest payments, had remained at 2.5 per cent for the second month running in May. This was only the second month that the old inflation target had been hit since the end of 1994.

The headline inflation rate rose from 2.4 per cent to 2.6 per cent last month, raised by housing costs and a jump in seasonal food prices during the month. The figures were slightly worse than the City had expected but nevertheless mean the new regime starts out from an excellent base.

In a letter sent to Mr George explaining the new system of open letters, Mr Brown wrote: "The actual inflation rate will on occasions depart from its target as a result of shocks and disturbances ... But if inflation moves away from the target by more than one percentage point in either direction I shall expect you to send an open letter to me."

The letter would explain why inflation was off course, what the Bank proposed to do about it and how long it expected it to take before inflation returned to target. If inflation was outside the one point bounds for more than three months, the Bank would have to send a second letter.

In his Mansion House speech, Mr Brown said the figure for the inflation target would be restated in every Budget.

"Instead of the old procedures that were ad hoc, personalised, and could not last credibly for the long term, this government has set in place clear rules, divisions of responsibility and a target supported by tight procedures for monitoring whether it is delivered," he said.

But Shadow Chancellor Kenneth Clarke was scathing about the details of the arrangements announced in the House of Commons yesterday afternoon. He asked: "How can you deny that you are loosening the inflation target by moving from 2.5 per cent or less to 2.5 per cent?"

"These are loosening the criteria for controlling inflation that the Bank previously had," Mr Clarke said.

Mr Brown reaffirmed in the speech his intention to be tough on fiscal policy too, with the Government borrowing only enough to finance public investment over the cycle.

City analysts' reactions to the new shape of the inflation target ranged from subdued to slightly disappointed. David Mackie at JP Morgan said: "In practice I don't think it will make much difference because the Bank is not going to be comfortable in the upper part of that 1.5 to 3.5 per cent range."

But Simon Briscoe at Nikko Europe said: "The apparently strict monetary policy regime that was unveiled a month ago is now being diluted."

In his speech to the City's finest at the annual Mansion House dinner last night, Mr George was somewhat more cautious about the Chancellor's move to take away the Bank's responsibility for banking supervision and give it to the new and enlarged Securities and Investments Board.

There were potential disadvantages in a super-regulator, the Governor said, and the outcome would depend on the way regulation was actually managed within the new structure.