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Last Updated: Wednesday, 10 December, 2003, 12:40 GMT
New target for inflation fight
By Steve Schifferes
BBC News economics reporter

The government has told the Bank of England to measure inflation in a new way, and given it a new target.

Chancellor Gordon Brown says that the Bank should use the harmonised index of consumer prices (HICP) which countries in the eurozone already use.

The new target will be 2%, compared to 2.5% the Bank has aimed for up to now.

The change will not affect the payment of benefits, which will continue to be indexed to the retail price index.

Lower inflation

The new measure of inflation, which will now be called the consumer price index (CPI), is already used in continental Europe and the USA.

It calculates changes in the prices of goods in the shops in a more reliable way than the existing retail price index (RPIX), Mr Brown said.

But because it excludes all housing costs - which vary considerably across Europe - it consistently shows that the UK has a lower inflation rate than if measured by the retail price index (RPI).

This month, UK inflation as measured by HICP was just 1.4%, compared to retail price inflation of 2.6% and the government's current target, RPIX, of 2.7%.

The difference between the two is so large because house price inflation, although slowing, was the biggest driver of price increases in the RPI.

The government's own target, RPIX, does exclude mortgage payments, but other housing costs, such as repairs, rents, insurance, and council tax, are included.

Will interest rates fall?

In setting its new inflation target, the government is assuming that, in the long-term, inflation as measured by HICP will be 0.5% lower than RPIX.

Old target: 2.5%
New target: 2%
ECB target: 2%
But the large difference between the two could create difficulties for the Bank of England in setting future interest rates.

The Bank's Monetary Policy Committee, which recently raised rates from 3.5% to 3.75%, would have to explain why it was raising interest rates further when inflation was below target, according to the new measure.

Although the Bank could say that it was worried about the projected future inflation in two years time, it would have a harder time convincing financial markets.

And the Bank may want to wait for a period to see if the gap between HICP and RPIX does narrow.

All this suggests that the Bank may be reluctant to raise interest rates again in the near future.

Indeed, if inflation stayed below target for a while, under the Bank's "symmetrical target", it would be required to cut interest rates instead.

The Bank is allowed a margin of 1% around the target inflation rate, just as it was when using the previous target, before it has to write a letter of explanation to the Chancellor.

European dimension

The main reason the Chancellor has given for introducing HICP is that it brings Britain in line with the rest of Europe, paving the way for eventual UK membership of the euro.

The European Central Bank, which sets interest rates in the 12 countries of the eurozone, also has a 2% inflation target.

But with the prospect of UK euro membership fading, the new HICP measure has the added advantage of producing inflation figures that flatter the UK economy compared to its continental rivals.

And if it helps keep interest rates on hold longer, that could be an added bonus.

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