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Bank of England Governor Mervyn King's letter to Alistair Darling

By Channel 4 News

Updated on 16 September 2008

Extracts from Mervyn King's letter to the chancellor explaining why inflation has again exceeded the government's 2 per cent target.

"Dear Chancellor

"In June I wrote an open letter to you when CPI inflation moved more that one percentage point above the 2% target. In that letter, I noted that inflation was likely to rise further and remain well above the target for a period of about a year or so.

"As a result, I expected to write a sequence of open letters to you - at three monthly intervals - as specified in the terms of the remit you have given to the Monetary Policy Committee."

Why has inflation moved away from the target?

"Inflation has risen sharply this year, from 2.1% in December, to 4.7% in August. Inflation is ultimately determined by the pressure of money spending on capacity, which is controlled by monetary policy. But, other factors both here and in the rest of the world can have temporary implications for inflation.

"As I highlighted in my letter in June, over the past year, there have been sharp, largely unanticipated, increases in the price of energy and food, reflecting developments in the global balance of demand and supply for these commodities.

"..The fall in the value of sterling pushes up on import price inflation, which, in the latest data for the second quarter of 2008 was around 12% - its fastest rate of growth in over twenty years. Import price inflation is likely to remain high as the effects of the exchange rate continue to pass through."

Over what period does the MPC expect inflation to return to the target?

"In the absence of further unexpected increases in energy and commodity prices, inflation should peak soon. Nevertheless, each monthly change in food, energy and import prices will, by altering the overall price level, affect the official twelve-month measure of inflation for a year.

"So CPI inflation is likely to remain markedly above the target until well into 2009, particularly if the recent depreciation of sterling is sustained. I continue to expect, therefore, that I will be writing further open letters to you over the next year."

What policy action are we taking?

"..the Committee has become firmer in its belief that a period of muted economic growth is necessary to dampen pressures on prices and wages and return inflation to the target in the medium term. But it is also aware that the slowdown in activity that is already in train could, if severe, result in inflation falling below the target in the medium term.

"Each month, the MPC sets Bank Rate on the basis of a fresh assessment of the balance of risks to CPI inflation around the target, using all of the available information. To date, the assessment has been that the risks around the target remain finely balanced, which explains why the MPC has maintained Bank Rate at 5% at each of its meetings since my previous letter to you."

How does this approach meet the Government's monetary policy objectives?

"Over the past decade, inflation has been low and stable. Volatility in commodity, energy and import prices may mean that inflation will be less stable in the future but it does not mean that inflation will persist at a higher rate. The actions of the Committee will ensure that the present rise in inflation is temporary and that it returns to the 2% target.

"In the short term, this commitment should give those setting prices and wages confidence that inflation will be close to the target in the future. That will minimise the slowdown in economic activity that will be necessary to ensure that inflation does indeed fall back to the target.

"In the longer term, price stability, as your remit to us states, is "a precondition for high and stable levels of growth and employment". The prolonged periods of subdued economic growth and high unemployment, needed in the past to reduce inflation from persistently high levels, deterred investment and contributed to poor economic performance over a longer period."

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