Clarke to hold firm on interest rates

Bank says rates must rise to stem inflation

COLIN BROWN

and PAUL WALLACE

Kenneth Clarke, the Chancellor, last night was at loggerheads with Eddie George, the Governor of the Bank of England, after a report calling for an increase in interest rates threatened to undermine the Gov-ernment's tax-cutting strategy.

Reinforcing its pressure for interest rates to be increased, the Bank of England warned in its monthly report that inflation was "more likely than not" to be above the underlying 2.5 per cent limit set by the Chancellor for 1997, if base rates remained at 6.75 per cent.

The forecast implies that for the fourth consecutive time Mr George, at their monthly meeting last Thursday, advised Mr Clarke to raise base rates. No increase has been announced, underlining the rift between the Chancellor and the Governor.

The Bank's report left Mr Clarke with a dilemma over his plans for reducing taxes in his next Budget. Andrew Buxton, chairman of Barclays Bank and head of the Confederation of British Industry's economic affairs committee, said: "One of my fears is that pressure on the Chancellor will lead him to propose tax cuts in the Budget which will fuel inflation and then we will get higher interest rates."

Business leaders have supported the Bank, but senior right-wing Tories warned that increasing interest rates would destroy hope of a revival in the housing market, which will stay flat, according to a gloomy report by the Halifax building society.

John Redwood, the right-wing challenger for the Tory leadership, accused the Bank of being "too cautious" over interest rates, and said the housing and construction industry was still "a long way from being overheated". Tax cuts could be sustained by cuts in public expenditure, he insisted.

Mr Clarke, officially on his summer holiday, was resisting the pressure for the interest rates rise, but may be forced to act, if that pressure becomes too great. He has insisted he will take tough decisions to defeat inflation.

Mervyn King, the Bank's chief economist, denied that credibility had been damaged by the continuing disagreement. However, he conceded that damage would be done if the Chancellor's and the Governor's views about the correct level of interest rates were to widen further.

The Chancellor avoided being dragged into a confrontation with Mr George by delegating Angela Knight, a junior Treasury minister, to deal with the controversy. She brushed aside the differences of view between the Chancellor and the Governor, saying there was a "wide margin of error" in economic forecasts.

"But allowing inflation out of the box would help nobody and we're not doing that. We take a judgment on interest rates. We've kept them down and that's good for the housing market as well," she said.

Mr Clarke's standing among Tory MPs sank with the debacle on taxing share options but they are backing him to the hilt in resisting interest rate increases. Privately they are sharpening their knives for the Governor's head, and are looking to Howard Davies, the former CBI chief, who is shortly to take up an appointment as Mr George's deputy, to change the policy of the Bank.

The Bank's warning was in line with the report of the Organisation of Economic Co-operation and Development that a one per cent increase in interest rates to 7.75 per cent would be needed to hold inflation to 2.5 per cent.

Michael Heseltine, the deputy Prime Minister, hailed OECD growth forecasts for Britain as a "dream target", which would revive Tory support. But a majority of Tory MPs fear Government housing policies could cost them their seats at the next general election, according to a poll published yesterday for Shelter, the housing charity.

John Townend, chairman of the Conservative backbench Finance Committee of MPs, led calls on Mr Clarke to phase out stamp duty on house sales as a way of revitalising the market.

Labour's deputy leader, John Prescott, said the Government had now not only lost the confidence of the Bank of England, housing market professionals and the City, but the Chancellor had lost the support of his own MPs."

Hamish McRae, page 15