Officials dampen hopes of rate cuts

Hopes for a cut in interest rates when Kenneth Clarke meets Eddie George next week were dampened by Treasury officials giving evidence to MPs on the Budget. However, the Ernst & Young Item Club, which uses the Treasury model, warned that interest rates could have to fall by up to 1.5 per cent to make the Budget strategy work.

Alan Budd, the Treasury's chief economic adviser, was asked whether growth of 3 per cent could be achieved next year without a fall in interest rates. Mr Budd replied: "Yes, I do think it is possible."

Another official, Colin Mowl, who heads the forecasting section, said that the Treasury did not expect that a cut in interest rates would be appropriate to "hurry up" the inventory adjustment that is now generally expected. Several City analysts are warning that a sharp temporary burst of destocking will depress growth in the next six months.

Mr Mowl said that the Treasury thought the economy would grow at 0.4 per cent in the last three months of 1995 and then pick up. This forecast of below trend growth in the final quarter took into account an adjustment of inventories. Subsequently, however, the official forecast spreads the effect more generally across next year and into 1997.

Mr Budd said that the Budget was neutral in the sense that the tax cuts were matched by spending reductions. However, the continuing downward path of the budget deficit, from pounds 29bn this year to pounds 22.5bn in 1996/7, meant that "in an underlying sense fiscal policy is being tightened."

In marked contrast to these views, a report by the Ernst & Young Item Club warned that interest rate cuts of 1 to 1.5 per cent appeared to be "the only way the government can meet the budget strategy". Paul Droop, chief economist, said that "recent economic developments have made the target of 3 per cent growth most unlikely. This means interest rate cuts would have to be very large to stimulate the sort of growth Mr Clarke's entire strategy depends on."

Mr Budd said that if the broad measure of the money supply, M4, continued to rise at its present rate of around 9 per cent, there would be "increasing causes for alarm" about the future rate of inflation. However, he added that there was no simple arithmetical relationship between the behaviour of broad money and the outlook for inflation.

The Treasury also cast more light on the drastic downward revision in expected tax revenues next year, from pounds 297bn to pounds 285bn. Tax cuts in the Budget accounted for pounds 3bn, but in addition three taxes were expected to garner much less than had been forecast at the time of the last Budget.

Income tax receipts would be pounds 2bn less (over and above the tax cuts) because the growth of wage and salaries had been less than expected this year. This would knock through to next year.