Inflation will breach target next year, Clarke's adviser warns

An adviser to the Chancellor of the Exchequer warns that inflation will be above the Government's target by the end of next year because of the pick-up in economic growth, in a report published today.

Kenneth Clarke's decision to cut base rates by a quarter point last month has already put him in danger of breaching the target. The move was "not consistent with a reasonable certainty that the target will be met", according to the latest forecast from the National Institute of Economic and Social Research.

The institute, headed by treasury wise person Martin Weale, says there is a one in four chance that inflation will be above 4 per cent by the end of 1997.

Yesterday's meeting between Mr Clarke and Eddie George, Governor of the Bank of England, ended with the apparent decision to leave base rates unchanged at 5.75 per cent. The reduction last month was the fourth since December.

According to the Government's target, inflation should be below 2.5 per cent on average and always within the range of 1 to 4 per cent.

The new forecast is pessimistic about inflation because it shares the Chancellor's optimism about growth with an outlook for next year's growth at the higher end of the scale.

The report says: "Our forecast indicates a substantial acceleration in economic activity in the second half of this year, continuing into next year. This acceleration has been encouraged by the recent reductions in the interest rate."

It predicts that unemployment will fall below two million in the early part of next year as a result of this pick-up in the economy.

Consumer spending is forecast to grow 3.5 per cent next year - less than the Treasury's extremely buoyant prediction of 4.25 per cent but still enough to deliver a growth rate of 3.4 per cent for the economy as a whole.

The national institute economists reckon growth next year will result in a better balance between consumer spending and exports. Improved demand for exports in Britain's main markets will help the manufacturing industry continue its recovery.

The report concludes the main pre-election difficulty for the Government will be the state of its finances.

Although it is less gloomy than the Treasury over the size of the public sector borrowing requirement this financial year and next and predicting shortfalls of pounds 25bn and pounds 24.2bn respectively, the report says it is not feasible to reduce existing public spending plans.

The report argues that the Government will be unable to agree to significant reductions in departmental budgets in a pre-election spending round. Even lower-than-expected inflation will not help it as budgets are set in cash terms and allocated at the beginning of the financial year.

"To produce a budget with unchanged spending plans, larger borrowing and lower taxes will give the Government some presentational problems, but this would not be unprecedented," the report says - noting wryly that this is exactly the situation which came about last year.

The report even denies the Government the fig leaf it has claimed in explanation for the huge overrun in borrowing last year. Recent Treasury forecasts have suggested that the normal links between economic activity and the level of tax revenues had broken down for reasons so far unexplained.

But according to the national institute, "there is little evidence yet that there has been a fundamental change in the relationship between tax revenues and economic activity more generally." The size of the Treasury's forecasting errors is not out of the ordinary, it says.