Osborne comes under pressure as inflation jumps to two-year high

Chancellor's plans to please so-called 'squeezed middle' hit on eve of Budget

The Chancellor George Osborne faces the Commons today to deliver his third major economic statement in less than a year against an increasingly difficult backdrop. Figures released yesterday show that Britain's manufacturing sector is performing better than expected, but inflation and the public finances are showing dangerous signs of weakness. The Office for National Statistics reported another sharp rise in inflation, to an annual rate on the Consumer Prices Index measure of 4.4 per cent in February, up from the 4 per cent rate in the year to January. That is the highest in more than two years, more than double the Bank of England's target and already in excess of the Bank and the Office for Budget Responsibility's official forecasts.

Among the 27 nations of the European Union, only Romania, Estonia, Greece and Bulgaria have a worse showing. One member of the Bank of England's Monetary Policy Committee has warned that inflation may rise to more than 5 per cent. The older Retail Price Index already stands at 5.5 per cent, up from 5.1 per cent.

Worryingly for the authorities, "core" inflation, which strips out volatile items such as food, fuel and energy – usually blamed for the rise – was also up sharply, from 3 per cent to 3.4 per cent.

Clothing has been one of the main drivers of inflation this month, up by 3.8 per cent – a record rise and far beyond any normal adjustment for post-sale prices. The annual increase in the cost of clothing this February was the highest since 1980, reflecting the spiralling cost of cotton on world markets.

Petrol and diesel prices reached all-time national average highs of £1.33 and £1.40 a litre respectively, and gas and electricity prices were also up by 0.4 per cent and 1.5 per cent on the month. The continuing ramp in food prices also prevented inflation from falling back as rapidly as many hoped – with items such as tea and coffee (up 10.5 per cent), fish (11.5 per cent) and fruit (10 per cent) squeezing household budgets.

The news will add to pressure on the Bank of England to hike interest rates sooner than expected, though the continuing fragility of the world economy, now under greater stress from turmoil in the Middle East and the disasters in Japan, may stay its hand.

The eurozone, too, is far from putting all of its troubles behind it; the eyes of international investors may be more focused on the Portuguese than the British Budget today. European leaders meet tomorrow to discuss the final terms of a new bailout facility.

The news on inflation and the public finances constrain Mr Osborne's freedom of manoeuvre. The Bank will be keener than ever for Mr Osborne to "stick to Plan A" and not stage any large, potentially inflationary tax give-aways.

The Chancellor will still be rewarded today with a shortfall in his borrowings of around £5bn to £7bn, compared to previous OBR forecasts, but that will be rather less than the £10bn that City economist had pencilled in.

Analysts say that the Chancellor may be forced to balance a relatively good performance this year against higher borrowings in 2011-12, while leaving intact his five-year "fiscal mandate" aim of eliminating the structural budget deficit and starting to cut the overall national debt.

Similarly, Mr Osborne will have to watch the OBR downgrade its growth figures for last year, after an exceptionally poor fourth quarter contraction of 0.6 per cent in GDP. This year's growth figures will probably be pared back from 2.1 per cent to closer to 1.6 per cent. Inflation is already above projected levels, and will have to be adjusted upwards again.

Having delivered a substantial emergency Budget last June and October's comprehensive spending review – which together formed a fiscal framework designed to take the Coalition through to an election in 2015 – Mr Osborne will be able to point to the revival in manufacturing as evidence that the economy is "rebalancing".

The CBI confirmed in its latest survey of industry that expected output volumes are at their highest since February 2007, while total order book volumes stand at their highest since March 2008.

Andrew Sentence, a so-called "hawk" at the Bank of England, pointed to the strength of the sector as evidence that the economy was faring better than often assumed and warned that inflation "could easily rise above 5 per cent later this year" and "failure to take timely monetary policy action risks a more abrupt and destabilising rise in interest rates in the future".

Osborne's Budget: What to expect

Economic forecasts

Expect the Office for Budget Responsibility to downgrade its growth forecasts for this year and next, as the economy has slowed faster than expected. For this year, growth will be revised down from 2.1 per cent to about 1.6 per cent. It will also say inflation will remain much higher than predicted.

Public finances

The Chancellor will probably beat his borrowing forecast in 2010-11 of £148bn by about £5bn, allowing him a little room for generosity. Next year, though, it is likely to go higher than the current estimate of £112bn; Mr Osborne will though be loath to alter his 2015 target of a balanced current budget, allowing for the economic cycle.

Taxes

The Chancellor has already said there will be no substantial giveaways, but a few moves have been widely trailed. Of great political interest will be the so-called "Learjet tax", but a more important review of the status and liabilities of non-doms may also be launched. The Government may increase further the amount individuals can earn before paying any income tax. Having pushed it from £6,475 to £7,475 he may raise it again to £8,000, but this time without "clawing back" the benefit from people further up the income scale. Most obviously Mr Osborne will cancel the scheduled 5p rise in fuel duty due in April and re-announce a new concession for rural areas.

Spending cuts

No more cuts of any magnitude will be announced, but the Chancellor may answer business concerns that infrastructure spending is one key to fostering growth. Growth and recovery will be the theme with three interlocking aspects – first will be the new "growth zones" with relaxed planning and employment rules rather than tax breaks. Second will be more help for smaller businesses to avoid employment tribunals. Third will be more help for the 974,000 young unemployed.

Merging Tax and National Insurance

An impossible task in one Budget or even 10, but another review with the aim of merging them is likely to be welcomed.

Sin Taxes

Tobacco and alcohol likely to be hit as usual, but room for manoeuvre is drying up as smuggling rockets.

Sean O'Grady