B of E policy rift with Clarke widens

PUBLIC disagreement over interest rate policy between Chancellor of the Exchequer, Mr Kenneth Clarke, and Bank of England governor, Mr Eddie George, deepened further yesterday when the Bank effectively called for the recent rate cuts to be reversed. The Bank of England insists in its quarterly "Inflation Report" that interest rates will have to rise in the next few months if the government's medium term inflation target is to be achieved.

This represents a marked change in the bank's stance from merely arguing against further reductions in the cost of credit. Its urgent call for higher interest rates stems from a gloomy analysis of factors likely to contribute to a revival of inflationary pressures over the next two years.

Domestic demand is accelerating, reinforced by rapid monetary growth and outlook for the public finances, says the bank's economists.

In the short term, the bank accepts that there could well be a further fall in underlying inflation, excluding mortgage interest, to under 2.5 per cent over the next six months or so. With such a favourable short term outlook, it admits, Mr Clarke may be tempted to ignore the inflationary consequences of faster growth of money and activity until inflation numbers start to rise.

On a two year view, though, the bank sees present circumstances leading to underlying inflation "a little above 2.5 per cent and rising with the risks more on the upside than the downside".

By then, however, it would be too late to prevent a sharper policy correction that would be more damaging to stability than an earlier pre emptive move, says the bank.

This two year projection is slightly worse than three months ago when the bank was still urging Mr Clarke and the Treasury not to reduce interest rates any further.

The advice was flatly rejected by Mr Clarke in late June when he lowered bank base rates by 0.25 per cent to 5.75 per cent, the lowest for 30 years, on the back of statistics indicating subdued inflationary pressures.

Now, with the general election - less than nine months away, Mr Clarke can again be expected to reject the bank's new advice to increase interest rates during the next few months, particularly as the bank is only warning of the possible risk reviving inflationary pressures nearly two years alter the election.

So far, events have proved Mr Clarke to be right in progressive reductions in interest rates over the past 18 months in the face of Mr George's persistent opposition.

Warnings of reviving inflation made by the Bank over a year ago have turned out to be wildly incorrect and, in the process, the bank's credibility has taken a severe beating.

At some time, of course, the inflation cycle will turn up and come to the rescue. But the prospect of falling inflation over the next few months may yet come to Mr Clarke's aid.