New inflation target could halt interest rate increases

The Bank of England was yesterday handed a new inflation target in a move some analysts said would put the brakes on further interest rate rises.

Gordon Brown confirmed the Bank must now target a standardised European measure of inflation, the Harmonised Index of Consumer Prices (HICP), which excludes housing costs and house price appreciation. The Chancellor saidthe Bank's monetary policy committee must set rates to hit a 2 per cent target, rather than its current target of 2.5 per cent under the Retail Price Index (RPIX).

From January the MPC will have to explain why it is not cutting rates when HICP - pronounced hiccup - is well below target at 1.4 per cent. This contrasts with the current RPIX, which is above the target at 2.7 per cent.

Ian Mitchell, of the Centre for Economics and Business Research, said rates would be "lower in 2004 than they would have been if we had stuck to the old target".

Earlier this year the Bank criticised the changeover, saying it was as if "someone behind you is moving the goalposts" as you were about to defend a free kick from David Beckham.

But the Chancellor said: "The long term credibility of our symmetrical target will be enhanced by adopting the internationally-recognised measure of inflation. [It is] more reliable because it gives a better measure of spending patterns [and] more precise because it takes better account of consumers substituting cheaper goods for more expensive [ones]."

The outlook, however, is further clouded by changes to the way inflation will be calculated. The RPIX includes housing depreciation - a proxy for house prices - as well as council tax and dwelling insurance. UK house prices have made up as much as 1 percentage point in the gap between the two measures.

Stephen Lewis, chief economist at Monument Securities, said the HICP was inferior. "Since housing costs bulk large in actual inflation, as experienced by UK households and in inflation psychology, they cannot be left out of the target without putting credibility at risk," he said.

But the crucial difference is a technical point few households are likely to grasp. HICP is calculated using a "geometric mean" while RPIX uses an "arithmetic" mean. Inflation rates of 4 and 9 per cent, for example, produce a geometric mean of 6.0 per cent but an arithmetic mean of 6.5 per cent.

Analysts said this usually produced a lower figure, with the difference often about half a percentage point.