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Is Kenneth Clarke's luck running out? Throughout his time as chancellor he has been able to set base rates with on...
Is Kenneth Clarke's luck running out? Throughout his time as chancellor he has been able to set base rates with one eye on the political situation and one on the state of the economy. Last May he disagreed with the governor of the Bank of England last May, arguing that rates should be left unchanged when the Bank were calling for an increase, and he was subsequently proved right. The economy slowed and base rates were eventually cut, with the full agreement of the governor.

Now the governor is calling for an increase in base rates to prevent a build-up in inflation pressures and the chancellor is arguing that they can be left unchanged. No doubt he is hoping to keep them at their present level - 5.75% - until the general election, which most political pundits expect to be held in May next year. However, the latest economic data increase the pressure for an interest rate rise, and it is possible, if not yet probable, that Clarke will have to put up base rates in the next few months, just as an insurance against being forced to raise them much closer to election day.

The latest retail price data show an increase in 'demand-pull' inflation pressures. The underlying rate of inflation moved up in September to 2.9%, further away from the target range. Retailers are trying to increase margins in areas where spending is strong, like clothing and footwear.

Some 'cost-push' pressures are also emerging. Average earnings are now growing at an annual rate of 4%, largely due to an increase in wage drift (i.e. overtime pay, bonuses etc.). There is scope for higher wage demands to push this figure up to 5% over the next year.

In addition, 'monetarist' inflation indicators have deteriorated. Narrow money is increasing at an annual rate of 7%, and this week's data showed that broad money (M4) rose 9.8% over the last year. In the past sustained money supply growth at this rate has usually led to inflation problems.

The only piece of good news for the chancellor has been the appreciation of sterling, back to its highest level in two years. He can argue that this represents a tightening of monetary policy, making it unnecessary for base rates to rise too. There is an element of truth in this argument, but, given the consumer-led nature of the present economic recovery, a rise in base rates, which would hold back consumer demand, would be preferable to a rise in sterling, which could impact negatively on exports.

However, there is probably not much the chancellor can do about the strength of sterling. It reflects a belief in foreign exchange markets that a future Labour government might take sterling into a European Monetary Union, at a rate against the DM above the current level. Ironically, as the prospect of a Labour government gets nearer, sterling may strengthen further, so making it easier for the chancellor to avoid an increase in base rates.

Mhairi Mackelworth, AMP Asset Management

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