Bank says rates must rise

The Bank of England warned last night that interest rates will have to rise for the Government to hit its inflation target. Mervyn King, the Bank's chief economist, said interest rates would have to rise "sooner rather than later".

The Bank's quarterly Inflation Report, released yesterday, made it clear than Kenneth Clarke, Chancellor of the Exchequer, rejected the advice of Eddie George, Governor of the Bank of England, at last Friday's monthly monetary meeting to increase base rates from the present level of 6.75 per cent.

The new Inflation Report contains a higher forecast of inflation for the next two years due to the fall in the pound since February. The Bank reckons inflation will approach the top of the 1-4 per cent target range, before falling to 3 per cent - above the 2.5 per cent Mr Clarke has repeatedly said he wants to reach by mid-1997.

Mr King said there was a great deal of uncertainty about the forecast for inflation, but the risks were that it would turn out even higher than predicted in the report.

Speaking in Aberdeen yesterday, Mr George said cost pressures due to the weaker exchange rate, which has led to a jump in import prices, could not be ignored. "You can't ignore inflationary pressures, whatever their source," he said.

Mr King, commenting on the Inflation Report, said the Bank could not act on the assumption that sterling would recover. Its forecast was already based on a "benign" view that the weak pound would have a one-off effect on prices but would not stoke inflation, he said.

The Chancellor defended his decision last week, responding to parliamentary questions about inflation prospects. He said: "We will continue to set interest rates to achieve the targets I've given." A Treasury spokesman said a peak inflation rate of below 4 per cent would still be a good result - the lowest peak in any business cycle since the war.

City analysts said it would be difficult for the Chancellor to turn down the Governor's advice again when they meet on 7 June - unless sterling has staged a miraculous recovery by then. David Walton, senior economist at Goldman Sachs, said: "The Chancellor has taken a risk with inflation. It would be difficult for him to say no twice."

David Miles, UK economist at Merrill Lynch, said: "The Bank has rubbished the Chancellor's arguments. It would be very hard for Mr Clarke to reject a base rate rise next month." Neil MacKinnon, Citibank's chief economist, said: "There is a case for leaving base rates where they are, but the weak pound certainly does jeopardise the inflation target."

According to the Bank of England's analysis, output is still clearly growing above trend. It cast doubt on the Chancellor's view that the latest gross domestic product figure was likely to be revised down.

The gilts market fell sharply in reaction to the Bank's gloomier inflation forecast. James Barty, an economist at Morgan Grenfell, said: "Markets trust central banks more than they trust politicians - and with good reason." However, sterling ended the day just over a pfennig higher against the German mark, at DM2.21, thanks in large part to a dollar rally.

The Bank's assessment was published on the same day that figures for retail prices showed headline inflation had edged down in April. But the Bank's preferred RPIY measure of inflation, excluding mortgage interest payments and indirect taxes, had increased.

The headline figure fell to 3.3 per cent, from 3.5 per cent in March. RPIY inflation rose to 2.1 per cent - its highest for more than a year. As well as expected rises in council rents, water rates and TV licences, there were increases in household goods and clothing prices.

A separate survey from the Confederation of British Industry suggested the retail climate improved last month. Its distributive trades survey showed a strong advance in retail sales volumes, making April the first month this year that sales have lived up to retailers' expectations.

Alistair Eperon of the CBI said: "The situation has improved since the beginning of 1995," although he cautioned that the trend in the past three months had been virtually flat. The biggest volume increases last month were reported by footwear and leather shops, followed by chemists, grocers and booksellers.

Official figures showing Britain's trade deficit widened in February, also published yesterday, revealed the effects of the fall in sterling. The total rose slightly to £1.16bn, while the deficit excluding oil and erratic items jumped by £300m to £1.8bn.

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