Tough Budget needed to conquer inflation, Bank warns: Prospect of tax increase re-emerges despite brighter outlook on prices

THE BANK of England said yesterday that the outlook for inflation had improved but it warned that a further reduction would require tough monetary and budget policies, which may include tax rises.

The Bank appeared cautious about any early cut in interest rates after London share prices eased from recent highs and the Bundesbank delivered a further setback to hopes that Continental rates would soon fall.

The FT-SE 100 Index, which analysts had expected to break through the psychologically important 3,000 mark in the next few days, fell back from Monday's peak, ending at 2,971.6, a loss of 14.8 points. The Bundesbank signal on rates drove sterling and European currencies lower, but gilt-edged and German bund futures reached new closing highs in the belief that rates in Britain and Europe would fall eventually.

In its latest Inflation Report, the Bank expressed confidence that the Government's preferred measure of inflation would remain within its

1-4 per cent target range over the next two years.

In spite of the brighter inflation outlook, the Bank hinted that it would prefer a further tightening in fiscal policy in the November Budget, which could include tax increases.

The Bank projected that underlying inflation, which excludes mortgage interest rates, would edge up to around 3 per cent by September. During 1994 it would move towards - although remain below - the 4 per cent ceiling because a switch from the community charge to the council tax would drop out of the annual comparison and the imposition of VAT on domestic fuel and power would push the underlying rate up.

But the Bank said this was an improvement on its previous projections. This was partly because the fall in inflation has been more rapid than expected, since falling unit labour costs have offset the impact of sterling's depreciation on import prices. Retailers' margins for food, drink and tobacco may have also been reduced.

However, the Bank is worried that companies could raise prices on the back of strengthening demand and that pay demands may exceed inflation until the target becomes credible.

It said credibility would be enhanced if the Government could curb its deficit and show that government debt would stop rising as a share of national output, putting to rest fears that the value of the debt might be reduced by means of a bout of inflation.

'It is important that adherence to the target range is not interpreted simply as holding inflation below 4 per cent a year,' the Bank said. The target also calls for underlying inflation, now 2.8 per cent, to ease into the lower half of the range by the end of this Parliament.

'That outcome is within reach provided that monetary policy does not accommodate increases in nominal costs, and that fiscal policy does not threaten the inflation target in the longer run.'

It added: 'Further fiscal action may be required, as the Government has recognised.'

The Bundesbank fixed an unchanged repurchase rate of 6.80 per cent, dampening hopes of lower rates and pushing sterling half a pfennig lower to DM2.5283. The French franc lost around 11 2 centimes to close at Ffr3.5204 to the mark, unaffected by rumours that Edouard Balladur, the Prime Minister, was about to resign. The Irish punt dropped 3.75 pfennigs to DM2.3360 after the market became convinced that Dublin was allowing the punt to float.

However, Gunter Rexrodt, the German Economics Minister, dismissed suggestions that the wider fluctuation bands within the exchange rate mechanism would lead to a permanent strengthening of the mark.

View from City Road, page 22