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King writes first inflation letter to Osborne

By Channel 4 News

Updated on 18 May 2010

Mervyn King has a new penpal, as the governor of the Bank of England writes to new Chancellor George Osborne to explain why inflation remains above the 2 per cent target. Faisal Islam reports.

Money in a wallet - inflation rose to 3.7 per cent in April (credit:Getty Images)

Driven by rising food costs and duty hikes in the recent budget, the Consumer Price Index (CPI) rose from 3.4 per cent in March to 3.7 per cent, according to figures from the Office for National Statistics (ONS).

It is the highest rate since November 2008 and more than the 3.5 per cent the City was predicting.

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The increase fuels suggestions that the Bank of England may need to raise interest rates to bring inflation back under control. But the Bank of England Governor Mervyn King argued the low interest rates and quantitative easing are "providing a significant boost to nominal spending which should continue for some time".

In his open letter to the chancellor, Mr King reiterated the Bank of England's latest forecasts that inflationwas likely to fall back below the 2 per cent target "within a year", but blamed high oil costs, a weaker pound and the rise in VAT to 17.5 per cent in January for inflation being "somewhat higher than expected over the past year".

He insisted that temporary factors were "masking the downward pressure on inflation" from the slack in the economy built up in a record recession. And he added that the bank was ready to "expand or reduce" the stimulus package for the economy, possibly paving the way for further quantitative easing.


In response, Mr Osborne urged the bank to be "vigilant", while acknowledging the "temporary factors" the governor referred to.

The headline rate of Retail Prices Index (RPI) also rose to 5.3 per cent from 4.4 per cent in March, the highest it has been since 1991, mainly as a result of higher mortgage payments compared to last year, when lenders were passing on the interest rate cuts.

Annual food inflation reached 2.6 per cent last month as many product prices rose, compared to falling prices last years. The ONS said disruption from the Icelandic volcano ash had little upward effect on food prices.

Alcohol and cigarette duty hikes in the March budget also added upward pressure, along with the rising costs of clothing and footwear.

The price of petrol also reached its highest level since records began in 1996, at 120.2p a litre, but the ONS said the impact on inflation was limited.

Economists reactions
Azad Zangana, European Economist at the global asset management company Schroders described the inflation figures as "terrible" and a "blow for the Bank of England".

"This release will sound alarm bells for the hawks on the Monetary Policy Committee, who have recently voiced their concerns about the risks of higher inflation feeding through to higher inflation expectations," he said.

"If inflation does not fall as fast as the Bank of England hopes, and soon, then we are more likely to see a rise in interest rates this year."

The TUC also described the figures as disappointing, but General Secretary Brendan Barber urged the bank to resist calls to raise interest rates to avoid the "risk of plunging us back into recession".

From Faisal Islam: Inflation alert leads to early debut of The 'Oz' and Mervyn show
So Mervyn King has a new penpal.

Prices are rising above target, and above forecast, yet again. And yet again the Bank of England says it is a temporary phenomenon that its interest-rate setting committee will "look through".

The question is: at what point does temporary become more enduring? If VAT goes up again on June 22nd, that will provide another boost to CPI inflation.

So when does the Bank start to raise interest rates, or quantitatively tighten (ie reverse QE)? Taken at their word, the bank and the Treasury believe the MPC can leave interest rates low for a long time, in spite of this bout of high inflation.

There is no fear of inflationary wage spirals, in the current jobs market, for example. Neither will many of the current sources of price pressures - oil prices, tax decisions - be reined in by a rate rise.

But then that means that the 2 per cent target is beginning to lose some of its lustre, some of its role as an anchor for prices. This slippery slope is seen as a more stable roadmap than the perilous road of simultaneous sharp rate rises and spending cuts.

The new chancellor's letter contains the crucial clue - almost half of it on the new fiscal policy and coming cuts. Osborne's hope is that the Treasury and Bank of England dance a tango of tight fiscal policy (spending cuts) and loose monetary policy (low interest rates). High and enduring inflation could wreck this dance.

Read more from Faisal Islam's blog

Hetal Mehta, Senior Economic Advisor to the Ernst & Young ITEM Club also said the figures would make the bank "uncomfortable", but that "we do not expect the Bank of England to increase interest rates this year in response to what is a short term pick up in inflation."

It was a view shared by Jonathan Loynes, Chief European economist for Capital Economics.

"Admittedly, the figures won't ease the concerns amongst one or two MPC members that inflation expectations might start to creep higher – particularly if a budget VAT rise pushes inflation itself even higher," he said. "But there is little evidence of that yet. And with a major fiscal tightening coming, we continue to expect interest rates to stay where they are for a long time."

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