Brown set to acccept case for rate rise

Diane Coyle

Economics Editor

Interest rates are likely to rise after Gordon Brown meets Eddie George, Governor of the Bank of England, on Wednesday. But the new Chancellor will face intense lobbying from industry to avoid any further rate rises as long as the pound stays so strong.

A business survey published today by the Institute of Directors confirms that the squeeze on export orders due to the pound's rise is being more than offset by buoyant home orders. The employers' group says it favours an interest rate rise to head off higher inflation.

It also joins the growing consensus that Mr Brown should use his first Budget to raise taxes too - although not for the purpose of fine-tuning the economy, but rather to fill some of the holes in the public finances.

The Bank of England is firmly expected to recommend an increase of a quarter to a half point in interest rates to trim the pace of growth and keep inflation on course for the 2.5 per cent target. The Chancellor is widely expected to agree.

David Walton, an economist at Goldman Sachs, said: "Gordon Brown seems likely to accept the Bank's recommendation, not least because he will want to bring to an end the previous Chancellor's dispute with the Governor."

The City, which hopes to see further moves towards independence for the Bank of England, would be concerned if Mr Brown refused the advice.

If rates do go up this week, most lenders would raise mortgage rates by a similar amount. A quarter point rise would add about pounds 10 a month to the cost of a pounds 50,000 variable rate mortgage.

However, exporters will hope for no further increases in interest rates for fear this would drive the pound's exchange rate even higher. Some of Britain's biggest companies have become increasingly vocal in their complaints about the impact of the strong pound on business, and will be making sure Mr Brown gets the message.

British Steel is expected to make a fresh effort later this week to persuade the Government to avoid using the interest rate weapon against the threat of inflation as long as sterling is hitting export orders.

It will join the bandwagon calling for higher taxes as an alternative. In a report published this morning, Lloyds Bank says tougher policies are needed to prevent consumer spending boiling over. Economist Trevor Williams said: "The onus shouldn't just be on raising interest rates. Taxes also have a role to play."

In its quarterly survey, the IoD recommends both, but for different reasons. It argues that the state of the public finances warrants tax increases.

Stephen Davies, its economist, said: "The idea that you can fine-tune fiscal policy to compensate for the exchange rate is absolutely ludicrous. The argument for higher taxes is based on the unsatisfactory fiscal position."

Although government borrowing is falling rapidly as the economy booms, many experts believe it should be even lower to satisfy the "golden rule" the new Government has pledged to meet. This says that over the course of the business cycle, borrowing will not exceed public sector investment. Meeting it early would imply a pounds 7bn-pounds 10bn increase in the tax burden on top of future increases inherited from Kenneth Clarke's last Budget.

The IoD survey confirms the picture of a two-speed economy. It reports that company performance has increased in the latest quarter, with output up and little change in orders.

Business and non-business services are the most buoyant sectors. They reported improved optimism, and the biggest increases in output and employment. They also saw the strongest increases in costs and prices, which were stable in other sectors.

Yet export orders have fallen, and there has been a decline in business optimism. Export orders in manufacturing have been particularly badly affected.