Markets expect Clarke fireworks

DIANE COYLE

Economics Correspondent

Expectations are growing that Kenneth Clarke, Chancellor of the Exchequer, will deliver a dramatic Budget when he stands up in the House of Commons tomorrow, despite behind-the-scenes attempts last week to play down the size of tax cuts.

Nick Knight, a prominent City of London strategist at Japanese bank Nomura, said: "What would be the point of fudging what could be his last Budget? He will be bold one way or the other."

Financial markets firmly expect both tax cuts and a fall in interest rates in the weeks after the Budget.

This has already cut interest rates paid in the money markets, which led Halifax Building Society to reduce its rates on investment accounts on Friday - a move that usually precedes a drop in base rates.

Other City analysts warn, however, that the Chancellor faces the risk of a run on sterling if financial markets think he is giving away too much on taxes. The pound weakened sharply a fortnight ago after "authoritative reports" that tax cuts would amount to pounds 5bn. Sterling has recovered only in the past few days due to market perceptions that the Treasury was trying to scale back expectations.

Neil MacKinnon, chief economist at Citibank investment bank, said: "Tax cuts without spending cuts would not go down at all well."

The reaction by financial markets to the Budget is crucial. It will be the deciding factor in whether there is room for a fall in the 6.75 per cent base rate and in mortgage rates.

Bijal Shah, an economist at Smith New Court, said: "Lower mortgage rates are the best way to put money into people's pockets."

The market reaction is likely to be mixed, analysts said yesterday. David Owen at Kleinwort Benson said expectations about the scale of tax cuts had been building. "There is a lot of room for disappointment."

Corey Miller, a strategist at Societe Generale, said there was a high degree of optimism about the Budget, but it had already been priced into the stock market.

Kevin Darlington, at brokers Hoare Govett, said financial markets were likely to give the Chancellor the benefit of the doubt immediately after the Budget. "But over time they could regurgitate what they might swallow instantaneously."

Hopes for reductions in personal taxes that would come into effect next April range widely, from pounds 2bn-pounds 10bn with a cluster around pounds 3bn. Income tax reductions are firmly expected, with 1p off the basic rate seen as the most likely option. Mortgage lenders still hold out some hope for a package to stimulate the housing market - perhaps the abolition of stamp duty - despite recent City optimism about house prices.

Health and education will be shielded from the spending axe. This is likely to cut most heavily into capital expenditure, especially the roads and housing programmes. The Government is likely to announce a greatly expanded Private Finance Initiative to fill this gap.

Some pounds 3bn will be found from the normal reduction in the contingency reserve - funds set aside for unforeseen spending, which are always cut as the financial year to which they apply draws nearer. Other departmental spending plans, such as defence and trade and industry, will also be cut back to offset tax cuts.

There are fears in the City that the Chancellor could also announce tax increases to make the public finances add up in a way that will keep sterling out of danger. A higher insurance premium tax is seen as a frontrunner, while higher taxes on the privatised utilities cannot be ruled out.

Richard Kersley, equity strategist at BZW, said: "The market has focused on likely winners. People have not paid attention to the fact that a broadly neutral Budget would create as many losers as winners." He said that attention was likely to switch to the opinion polls and Labour Party policies as soon as this year's Budget was out of the way.

Gavyn Davies, page 19