City seeks hard inflation stance

Traders are braced for an interest-rate rise and are waiting to see if Gordon Brown will be tough enough to announce one after the scheduled monthly monetary policy meeting between the Governor of the Bank of England and the new Chancellor on Wednesday.

Mr Brown will be anxious to demonstrate to the world's financial markets that he is at least as tough on fighting inflation as his Conservative predecessor, Kenneth Clarke, who pushed price rises down to their lowest levels in 30 years.

"There will be a hiatus before the mini-Budget in six to eight weeks, but markets will watch his every move," said Simon Briscoe, an economist at Nikko Europe. "His posturing on base rates will be a key component of building market credibility."

Labour has worked hard to shake off its old image of high taxes and high spending. During the election campaign, Mr Brown said his interest rate policy would be shaped to meet the same inflation target the departing Conservatives had aimed at but never hit, an annual 2.5 per cent.

Analysts said that meant rates would rise. "We think the size of the majority will make it more likely that Labour will pursue a tight monetary stance,'' said Andrew Cates, an economist at UBS. "The strength of the economy and a wish to gain anti-inflation credibility leads us to expect a quarter-point rise in base rates, taking them to 6.25 per cent."

The latest economic reports bolster the case for higher rates. Gross Domestic Product expanded at an annual rate of 3 per cent during the first quarter, and average earnings increased a surprising 5 per cent rise during February, sparking concern that a tighter labour market is leading to wage inflation.

Many economists now expect interest rates to rise by 0.25 per cent this week and a full percentage point by the end of the year.

While final responsibility for monetary policy lies with the Chancellor, Bank of England Governor Eddie George will almost certainly advise Mr Brown to raise interest rates when the two meet on Wednesday.

Acting quickly would allow Mr Brown to avoid any political opprobrium as he can blame his predecessor for making such a step necessary.

But there are good economic reasons why the new Chancellor might delay an immediate move. The greatest danger the new government faces is not inflation but an overvalued pound which has risen 17 per cent against its trade-weighted index since last August.

A rate increase would make sterling an even more attractive investment relative to the mark or the dollar, eroding the competitiveness of British exporters and threatening the manufacturing recovery.

The National Institute for Economic and Social Research believes there is no need to raise borrowing costs as the strong pound is keeping inflation down and says any rate rises would have to be reversed in the autumn if sterling remains high.