Less is more with new improved euro-style inflation yardstick

Interest rate decisions by the Bank of England will be based on a new inflation target of 2% from next month following the government's decision to move to the internationally agreed yardstick for measuring the cost of living, Gordon Brown announced yesterday.

Faced with a possible backlash from the elderly, the chancellor said that pensions, state benefits and index-linked gilts would continue to be calculated using the retail prices index.

However, unions were unhappy that the chancellor has decided to use the new lower target as the basis for wage ne gotiations in the public sector. Brendan Barber, general secretary of the TUC, said: "The chancellor seems to be saying that public sector bodies will be expected to use the new lower inflation measure, while everyone else will be using the established price index.

"If this is going to be used to hold down wages, it will send alarm bells ringing throughout the public sector. We will be seeking further discussions with the chancellor on this as soon as possible."

The new inflation target - to be called the consumer prices indicator or CPI - was flagged up in June when the chancellor announced that Britain was not yet ready to join the euro. Changing the inflation target to the one used in the eurozone was a way of showing that Labour remained committed to joining the single currency in principle.

Mr Brown said yesterday that the CPI would be more reliable because it took account of spending by all consumers and that it would be more precise because it would make allowances for cheaper goods being substituted for those that were more expensive.

The chancellor told MPs he had written to the Bank's governor, Mervyn King, to tell him that the monetary policy committee should use the new measure when it meets to decide on interest rates in early January.

As with the current measure - the retail prices index excluding mortgage interest payments - the target will be symmetrical, forcing the Bank to be as concerned if inflation undershoots as if it overshoots. Should inflation deviate by more than one percentage point on either side of 2%, Mr King will be obliged to write an explanatory open letter to the chancellor.

City analysts said yesterday that the change-over would make life more complicated for the MPC. On the RPI(X) measure, inflation has been slightly above its target, making it relatively easy for the Bank to justify the increase in interest rates announced last month. On the new measure, however, inflation is only 1.4%, well below its target.

The government says 2% on the new CPI measure is the equivalent of 2.5% on the RPI(X) measure, with the big divergence seen at present accounted for by house prices, which are included in RPI(X), but not in CPI. The Bank expects house price growth to moderate and this should see the two converge.

Financial markets are expecting the Bank to push up interest rates by around one percentage point in 2004 following the quarter-point increase to 3.75% in November. Last night the City consensus was that the MPC would allow a month for the new system to bed down and for it to be explained fully to the public before it pushes up borrowing costs in February.