View from City Road: Hope of early rate cut disappears

The chances of an early cut in interest rates have as good as evaporated. Yesterday's gross domestic product figures confirm that the recovery has built up enough momentum to absorb Kenneth Clarke's tax increases without undue pain. There is also gathering evidence that the flames of inflation are flickering again in the labour market.

The economy has now recovered all the ground it lost during the 1990/1 recession, with output of goods and services 4 per cent above its trough two years ago. True, the picture is flattered by booming North Sea oil and gas production; the pace of recovery may also slow slightly as the effect of the tax increases builds up in the next few months. It seems clear, however, that growth is already too well entrenched to be brought to a halt.

Not that growth of 2-2.5 per cent is necessarily a harbinger of imminent inflationary problems. Inflationary pressure normally only kicks in with a vengeance when growth accelerates further. Tax rises will delay this for a while by subduing high street spending. There are, however, signs from the labour market that pay settlements and earnings growth are beginning to pick up once more, while unemployment has fallen more quickly than in the aftermath of the last recession. Incomes Data Services noted yesterday that Burton and Next, the clothes retailers, had granted extra pay increases in parts of the country where there was a shortage of qualified workers. 'Such moves are reminiscent of responses to the tight labour markets of the 1980s, when unemployment was around half the current level', IDS noted.

Inflation optimists argue that these trends are evidence of newly won flexibility in working practices and of the specific pressures exerted by more competitive markets for goods and services. A more likely possibility is that the economy is growing more quickly than the official statistics suggest, perhaps because too much of the rising level of exports is being attributed to price rises rather than higher output.

The jury will remain out on both the state of the labour market and the impact of the tax increases for some months.

In the meantime the Chancellor appears to have accepted that there is no case now for a rate cut, although the minutes of his recent meetings with the Governor of the Bank of England suggest that he would happily use a couple of months of inconclusively weak data as an excuse to cut again. If that's his plan he should beware; this would only bring the first rise in interest rates that little bit closer. That's certainly the way the markets would view it; the effect on equities and bonds would probably be deeply negative.