Rate rise likely after election

The general election campaign is likely to get under way in an inflation environment that is more favourable than at any time for a generation, statistics this week are expected to show.

It is not yet clear, though, that this will be sufficient to prevent a rise in interest rates of a half percentage point soon after the formation of the new government.

The producer price index published tomorrow is a reliable indicator of future inflation. Prices that manufacturers pay for their raw materials are expected to have fallen 6.1 per cent in the year to February after a decline of 6.2 per cent in January.

The rise in the pound of more than 15 per cent since the beginning of last August is one of the main reasons why prices are falling. The threat of increased competition from imported goods is expected to have dampened manufacturers' price increases to as little as 1.4 per cent.

"During February, the pound rose by one and a half percentage points on its trade-weighted index, suggesting a further drop in the cost of imported goods," said Philip Shaw, chief economist at Union Discount.

The producer price index has fallen for the last four months but this has yet to feed through into retail prices. The underlying rate of inflation, which excludes home loans, remains stubbornly stuck above 3 per cent, in excess of the Government' s target of 2.5 per cent. The approach of the general election has kept rates on hold in the first quarter of the year even though Chancellor of the Exchequer, Kenneth Clarke, said last week the prospect of a general election within months wouldn't prevent him from raising interest rates.

"The belief that politicians can't change interest rates before an election is old-fashioned nonsense," Mr Clarke said.

No one expects him to act on his word. Mr Clarke has consistently pointed to the deflationary effect of the strong currency to back his decision to keep rates unchanged at 6.0 per cent.

"I am reassured by the exceptional lack of inflationary pressures in the pipeline," he said last week.

Since the end of the Second Wold War, British interest rates have been raised just twice in the six months before a general election - in 1955 and 1979.

Economists are now focusing on what will happen to rates once the general election, now less than two months away, is over.

The latest opinion polls last week showed the Conservative party was trailing Labour by 26 percentage points, the worst ever rating recorded by a governing party in the final weeks of a parliament and further evidence that 18 years of Conservative government are drawing to a close.

A Labour government is expected to demonstrate its commitment to economic prudence. Shadow Chancellor Gordon Brown has said an incoming Labour government will adopt the current inflation target of 2.5 per cent or below, pointing to an early rise in rates.

"I expect a rise of 50 basis points in June," said Andrew Milligan, chief economist at GA Investment Management. "Rates should be flat after that until the year end on the assumption that fiscal policy is tightened in the Budget."

However, some investors are starting to scale back their expectations on rates.

"The consensus view has been that rates will be raised immediately after the election but the market is starting to question whether the case for higher rates is really that strong," said Richard Morrissey, senior bond analyst at McCarthy, Crissanti & Maffei.

In addition to falling import prices, oil has also declined, with the price of Brent crude down by 20 per cent since the beginning of January. Recent anecdotal evidence from CBI surveys suggest diminishing price pressures in retail goods.

The retail price index for February will be published on 20 March. Copyright: IOS & Bloomberg