Base rate rise sends the pound soaring

A surprise increase in base rates yesterday sent the pound soaring on the foreign exchanges to its highest level for two and a half years. But shares and gilts fell sharply, even though Kenneth Clarke, the Chancellor of the Exchequer, insisted he had nipped inflation in the bud.

He predicted the economy would grow by more than 3 per cent next year. "This means we must take no risks with inflation now or in the future," he said.

Eddie George, Governor of the Bank of England, welcomed the decision to raise rates by a quarter of a percentage point to 6 per cent. "It improves the chances of achieving the Chancellor's inflation target, and so also of sustaining the expansion into the medium term," he said.

However, Shadow Chancellor Gordon Brown said the move revealed the economy's underlying weakness. "This is a Government forced to push up interest rates because it does not believe it can meet its inflationary target," he said.

In explaining his decision, Mr Clarke referred to recent figures showing higher growth in the third quarter of this year, and upward revisions to earlier growth figures. The pick-up in activity he had forecast was now well established following mixed signals during the summer.

City economists inferred that Mr George had given firm advice for rates to go up at yesterday morning's monetary meeting at the Treasury. The Governor had made it clear for months that he regretted the quarter point cut in the cost of borrowing in June and would prefer a higher level.

"The Chancellor had to weigh up whether to agree, or risk a damaging escalation of his dispute with the Governor. He concluded it was better to go sooner rather than later," said David Walton at investment bank Goldman Sachs.

The decision caught many in the City on the hop, however. "It is a mistake. I am cheered only by the fact that it is a small mistake," said Roger Bootle, chief economist at HSBC Markets.

He warned that the resulting rise in the pound, which climbed more than 3 pfennigs to DM2.4607 yesterday, would halt the tentative recovery in manufacturing.

Others thought the move was overdue. "I can't think of any time when the economic data pointed more clearly to the need for a rate rise," said Kevin Gardiner at Morgan Stanley. He added: "The Chancellor has also made it more likely he can make it through to the election without a dramatic increase."

Views were mixed about whether the Bank of England's Inflation Report, due next Wednesday, would now predict that the Government was more likely than not to meet its 2.5 per cent inflation target. Financial markets are betting on another quarter-point increase in base rates by the end of the year.

But City economists were less gloomy. "The Bank is likely to conclude that inflation will still be above target in two years, but the Chancellor has probably done enough to see him through to the election," predicted Mr Walton.

There were also concerns that the base rate rise would give Mr Clarke the chance to get away with bigger tax cuts in next month's Budget. Adam Cole at broker James Capel said: "It clearly increases the risk that the tax giveaway will be more generous than we previously thought."

He said tax increases and unchanged interest rates would have been a better policy mix with manufacturing still weak but consumer spending roaring away.

On the other hand, there was a welcome from the Skipton Building Society. Spokesman David Charlton said: "It allows for tax cuts in the Budget, putting more cash in the pocket of the consumer."

He said yesterday's rise would have no impact on the housing market, given that competition in the mortgage market remained fierce.

The country's three biggest lenders all said yesterday that they had no immediate plans to increase mortgage rates. The Halifax said it would also be waiting to see what the Budget held.

"Abbey National has no plans to change its mortgage rates in response to a minimal base rate move of 0.25 per cent," said Charles Toner, deputy chief executive.

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