Chasing the wrong target

AS he promised at the time of his euro assessment in June, the Chancellor has pressed ahead with the most radical change in Britain's interest rate setting since the creation of an independent Bank of England in 1997.

Out goes the most closely-watched measure of inflation RPIX - which is the old retail prices index less mortgage and tax changes - and in comes the European Harmonised Index of Consumer Prices (HICP), known to its admirers as Hiccup.

Why Brown, not known for his strong European credentials, is determined to make this change is not clear. But it is generally assumed to be part of his deal with the Prime Minister to demonstrate he is 'on message' with Labour's medium-term plans to take Britain into euroland.

No one listening to Brown's exposition of our own economic performance, vis-a-vis that of our European partners, could be unconvinced that on almost every other measure, from growth to budget deficits and unemployment levels, there is no harmony with Europe at all.

Indeed, rather than actually adopt the European title for the new inflation index Len Cook, at the Office of National Statistics, has come up with the original name of Consumer Prices Index (CPI) - which by happy coincidence is what the Americans call their inflation index.

Adopting the CPI is not without its headaches. The good news is that on the CPI measure, British inflation has been running consistently lower than on the RPIX measure.

At present, the difference between the two rates is 1.3%. But the Treasury believes it will fade away to half a point in two years.

In view of these differences Brown has written to Bank of England governor Mervyn King to tell him that the inflation target - held at 2.5% since 1997 - is to be lowered to 2%.

Any divergence either way from this 1% target will, as before, require King to write a letter to headmaster Brown to tell him why the Bank of England and the MPC have got things wrong.

The adoption of the new inflation target could well present King and the committee with some presentational problems in 2004.

No one doubts that the bottom of the interest rate cycle was reached at 3.5%, and with the November increase to 3.75%, rates are on the way up. Even the super-cautious Federal Reserve has signalled that higher US rates are on the way.

But if CPI inflation is running well below the 2% target on the Bank's projections, it will be that much more difficult to explain why interest rates are rising. Several factors are likely to push up the cost of money in the coming months.

Government borrowing has to be financed through gilts sales and other devices, including national savings, which require competitive interest rates.

Then the Bank may feel the need to continue to restrain borrowing in the household sector, which has been running at record levels, unless there are indications that the quarter-point rise already has done the trick.

Finally, manufacturing will also be demanding more investment cash. These competing demands for money are each likely to put upward pressure on rates.

The only real question is how high they will go. The money markets predict a rise to 5% by the end of 2004.

Simon Rubinsohn of Gerrard believes it is going to be 'difficult to justify a significant increase in rates unless inflation begins to approach the new target'. He says a modest half-point rise over 12 months is a more likely outcome.

Tory economic spokesman Oliver Letwin is puzzled by the timing of the decision to switch from RPIX to the new CPI.

He rightly points out that Eurostat, the Brussels equivalent of the Office of National Statistics, is working on revisions to HICP to include an element of housing costs.

Yet housing is one of the key differences between the current RPIX measure and hiccup. So the whole complex switch and retargeting is unnecessary.

Not so, says the Treasury. Europe's definition of housing cost relates to maintenance costs, not house prices, like the element in the RPIX. So there will be no need to adjust the target again when housing is included.

Though no doubt the new measure of inflation will be far more statistically valid, the switch at this juncture does seem like change for change's sake and will make life more difficult for everyone from employers to the Bank of England.

But meddling has become a way of life in the Brown Treasury.