How Long Before Rates Have To Rise?

Is Britain's economy slowing to a noninflationary pace, or isn't it? Chancellor of the Exchequer Kenneth Clarke says yes. Bank of England Governor Eddie George says no. And the six "wise men" aren't sure.

Score Round 1 to the Chancellor. In the face of confusing data, Clarke is believed to have rejected George's May 5 request for a rate hike that would have lifted base rates for the fourth time since September from 6.75% currently. That came despite a still solid advance in first-quarter gross domestic product and a plunge in the British pound. Clarke's veto, coming just after the Conservative Party's local-election trouncing, seriously undermined his credibility with the financial markets as an inflation fighter.

However, sterling has since rebounded, and on May 24, first-quarter GDP growth was revised down. The details suggest that Britain is really two economies now: one driven by strong exports and one suffering from weak domestic demand. The downward revision gives Clarke the ammo to resist another plea from George at the June 7 policy meeting.

However, with price pressures building, Clarke may not be able to resist for long. While headline retail inflation slowed to 3.3% in April as the impact of new taxes faded, core inflation, minus taxes and mortgage costs, has risen to 2.1%, nearly a percentage point above its low point last July (chart). Core producer inflation has picked up even more, and despite the GDP revision, growth remains above its noninflationary trend of about 2.5%.

The central bank's May inflation report argued that, without higher rates, the government will not be able to meet its inflation target: 2.5% for the core retail price index by early 1997. And on May 23, three of the six wise men, the government's independent economic advisers, said higher rates would be needed just to keep inflation below 4%. Clarke's dilemma: Raising rates could send the weaker Britain into recession, while no action could fuel inflation in the other Britain.

Before it's here, it's on the Bloomberg Terminal.