UK warned on threat from renewed inflation: A new analysis questions British fiscal policy and urges international reforms to improve employment prospects. Peter Torday reports

THE ORGANISATION for Economic Co-operation and Development yesterday urged the UK government to be cautious about further interest rate cuts after warning that the risks of rekindled inflation may threaten recovery.

The OECD also questioned whether the Government could avoid a significant tightening of fiscal policy - and might ultimately have to raise taxes - over the next two years to reinforce the markets' faith in anti-inflation policies.

The fall in rates so far, coupled with depreciation of the pound, was likely to raise demand and inflation next year, the OECD's semi-annual Economic Outlook said. It forecast inflation, as measured by the GDP deflator, a gauge of domestic costs, would ease to 5 per cent in 1993 from 5.4 per cent a year earlier. But it warned that 'the need to restore credibility in financial markets and put inflation expectations on a downward track may ultimately place a floor below UK rates, even as rates in other European countries come down'.

The risk that inflation would exceed the official target of a 1-4 per cent range 'is not negligible', the OECD said. High import prices threatened following the devaluation of the pound and 'the authorities have a difficult task of building public confidence in a policy course that restores growth and contains inflation'.

For Britain and other countries whose currencies have recently depreciated, there was also a risk that a wage-price spiral would develop unless offsetting policies were put in place. The OECD nevertheless questioned the viability of monetary policy outside the exchange rate mechanism. 'The credibility of the anti-inflation strategy that was being built via the link to the mark has been relinquished, and will need to be rebuilt.'

It noted that inflation expectations - as measured by the differential between indexed and long-term conventional gilts - were running at 4.8 per cent, and needed to be brought down.

As a result, recovery in Britain was clouded by unusual uncertainty next year because of sterling's enforced departure from the ERM.

The OECD forecast that the economy would expand by 1.3 per cent next year - a prediction in line with the Treasury and the average expectation of the Government's independent panel of seven wise men. Thereafter, the OECD believed that growth would return to its long-term potential expansion rate of 2.4 per cent.

But it cautioned that the outlook was clouded by 'an unusually high degree of uncertainty'. Consumers and businesses might continue to repay debts at a rate that delayed recovery, despite the easing of monetary policy.

The organisation also took issue with the Chancellor's belief that most of the deterioration in the budget deficit was due to recession. As the debt to national output ratio climbed, some 30 per cent of the deterioration - roughly pounds 12bn - was structural in nature and would have to be contained, it said.

But assuming the Government stuck to the new controls on public spending over the next three years, the OECD estimated that growth in 1994 would be strong enough to curb the growth of public spending as a proportion of national output, thereby tightening fiscal policy.

Nevertheless, it implied that higher taxes or further public spending curbs might be needed to reassure the markets. 'A significant reduction' in the structural budget deficit - the portion of the budget shortfall not directly attributable to the recession - might be required 'to convince markets of the Government's commitment to a medium strategy of low inflation'.

The OECD said that its prediction of a return to trend growth in 1994 assumed that 'macroeconomic policy attaches high priority to inflation control over the medium term and establishes its credibility in this respect'.

Assuming the Government acted as it hoped, the OECD expected that after rising to 11 per cent of the labour force in 1993, unemployment would fall slowly.