Chancellor and Governor in opposition

IT was perhaps inevitable that after a seven-year honeymoon for the Government and the Bank of England, we would now be seeing signs of a seven-year itch.

Earlier this month, for the first time since Mervyn King took over as Governor of the Bank a year ago, there were definite signs of tension between him and Chancellor Gordon Brown. Urgent attempts were made to present this as no more than a spat about the cost of the marital home and the likelihood or otherwise that it, and all the others in the country, might suddenly drop in value.

But the rift runs deeper and might even suggest they are going their separate ways. Although King has yet to say so explicitly in public, the real reason for the tension between them is surely that the Governor doubts his ability to use higher interest rates to maintain stability and prevent overheating in the economy when the Government's massive tax and spending programme is adding daily to that instability.

King thinks that the way the Chancellor is running the economy will force interest rates up much further than they would otherwise need to go. The Chancellor wants to stop him saying this - or even looking as though he is thinking it.

In economic parlance, monetary policy and fiscal policy are not operating in tandem. This became obvious last December at the time of the autumn Budget statement when the Treasury's projections for growth and output seemed to bear little resemblance to the model being used by the Bank.

Eminent economists such as Cambridge's Wynne Godley were pointing out last year the obvious danger for the UK when the two navigators of our economic system use different maps. Now, however, with the economy failing to respond to the Bank's interest rate driven messages of restraint, the problem is becoming acute.

The Bank clearly thinks the Chancellor should rein back his spending or run the risk that inflation in the public sector will infect the rest of the economy.

The Chancellor worries that further interest rate rises could cause a house-price slowdown just when Prime Minister Tony Blair goes to the country, and could cost Labour dearly at the polls. But the only one who could change the course of events is the Chancellor, and the politics being what they are, he seems highly unlikely to do so.

There is, however, a bit more to it. As Tony Rudd points out in his current internet investment letter, the monetary policy committee for the first time in its life finds itself at a turning point in the global business cycle, where interest rates round the world are being raised and inflation is very much back on the agenda. It was fortunate in its early days to operate in relatively benign conditions. From now on it will find things much tougher.

All this is about to come to a head with the publication of the Government's spending review. So many promises have been made, and the Labour party has so completely thrown off its mantle of prudence, that it is almost impossible to see what Brown can come up with that will go far enough to meet his bank manager's concerns.

If he fails, the tensions between them are likely to continue and become more and more evident in policy - including higher interest rates and all the pain they will bring.

It is an irony, which has no doubt already occurred to the Chancellor, that the giving of independence to the Bank of England which has been hailed as his greatest achievement, might yet be the one that does most

to undermine Labour's prospects of a third term.

Master plan

I DID an injustice to Railpen and its predecessor, the British Railways Pension Fund, the other day when I said its policy of investing in works of art in the 1970s did not really work.

The chief executive of the trustee company, Chris Hitchen, tells me that when the portfolio was sold, it produced a return of 4% a year above inflation over its 30-year life, which was probably a lot better than its sponsors could have hoped for in the dark days of 1974 when inflation was soaring and the stock market sinking.

When the policy was conceived there were no index-linked gilts, so matching inflation-linked pensions was a real problem. The art investments were an imaginative solution to the problem faced then, perhaps as now, of equities and bonds looking like they were in for a rocky ride.

Let's hope the young masters in the hedge funds into which Railpen is diversifying do as well for it as the old masters in the art galleries did.