New stealth tax from the Chancellor?

THE old expression 'If it's not broke, don't fix it' sprang to mind as I listened to the Chancellor's Pre-Budget Report.

In the speech he announced that the Bank of England's monetary policy committee would be asked to discard its 2.5% RPI-based inflation target. Instead, it would have to adopt a new target of 2%, based on a measure of the cost of living - now named the Consumer Price Index (CPI).

This change would matter little if the two inflation measures were similar, but they have behaved very differently from one another in the past and will continue to do so. Inflation under the old RPI-X measure is 2.5%. Using the new CPI it is just 1.3%.

The difference stems from the fact that the older inflation measure includes some important expenditure items that are excluded from CPI. The most obvious relates to housing, but there are also other omissions, such as council tax.

With double-digit house price inflation and with council taxes increasing by 12% over the last year alone, it doesn't take a genius to see why RPI-X inflation is currently nearly twice as high as CPI inflation.

Indeed, over the last 10 years, inflation as defined by the RPI-X measure has always been significantly higher than that defined by CPI.

The change in the definition of inflation has increased uncertainties regarding the path of interest rates, particularly over the next 12 months. Before the Chancellor's announcement, the consensus was that the MPC would raise interest rates by between 0.75% and 1% over 2004. But now the inflation definition and target have changed.

The Bank of England's Governor Mervyn King has likened the predicament of the MPC to that of a goalkeeper preparing to face a free kick, only to find that someone has moved the goal posts behind him.

So how will the MPC respond to this change in 2004?

It could still raise rates by 0.75% to 1%, as expected before. But King and his colleagues would have a difficult job explaining why interest rates need to rise at all over 2004 when the new measure of inflation at 1.3% is so far below its 2% target.

The risk then is that the MPC may raise rates less rapidly than otherwise might have been the case, despite its obvious concerns about consumer borrowing and house price inflation.

Consumer-debt levels are already at record highs. Any acceleration in borrowing caused by a delay in rate rises next year would damage the UK economy's long-term growth prospects. And growth, as we know, means jobs.

Given the clear risks involved in moving the UK from a position where inflation was fractionally above target to one where it is now substantially below target, why did the Chancellor feel the need to fix something that wasn't broken? Or indeed to break something that was functioning well?

The European Central Bank effectively targets 2% euro-area inflation under CPI. The Chancellor's aim then is to make UK monetary policy similar to ECB policy.

Thus, the logic went, the change would make it easier to adopt the euro should we vote to do so in the future. But since Britain has just 'failed' the Chancellor's own five economic tests for joining the euro, such a move could be seen as an unnecessary gesture.

To risk adding further fuel to the UK's borrowing inferno by adopting this new inflation target seems like a very high price to pay just to keep New Labour Europhiles happy.

Real cynics might suspect another reason for the monetary policy change. In his speech, the Chancellor ruled out linking benefits and pensions to the new definition of inflation. Good news for those on benefits or receiving a pension, since such a move would have meant smaller rises in the future.

However, more notable was his silence on how the change might affect income tax. Should the Iron Chancellor choose to link future increases in personal income tax allowances to CPI inflation instead of to the older, higher measure, then the Treasury's revenue from this tax would be higher in the future.

A Chancellor looking for new ways to raise tax revenue? Surely not!

Over 2004 the UK economy needs to make the transition from one where growth is driven by low interest rates and borrowing, to one where growth is driven by investment and productivity gains. The challenge for the MPC is to make this transition as smooth as possible.

Whatever the Chancellor's motives for his new monetary policy fix, let's hope that he hasn't made their job more difficult.

Andrew Clare is financial economist at Legal & General