Is Inflation Out Of Control?
Mervyn King has been forced to pen his famous letter. How high will interest rates need to go to tame inflation?
For the best part of a decade, economics in this country has been rather dull. If nothing else, the rough patch we've hit signals an end to the monotony. News of an unexpected jump in inflation to 3.1% on the consumer price index triggered the first-ever letter from the Governor of the Bank of England to the Chancellor to explain why prices are more than a percentage point above target.
The racing certainty of higher interest rates also sent the pound past the $2 mark for the first time since the early Nineties. But we shouldn't be too rattled: as former MPC member Sir Alan Budd points out, the real surprise is that the letter wasn't sent sooner.
When the bank gained independence, we thought the letter would have to be written every 15 months; the fact that it took ten years is a miracle.
It's clear from the tone of Mervyn King's letter, and the Chancellor's reply, that both are remarkably confident inflation will soon head back to its 2% target. That confidence is unjustified. Once inflation is let loose, it is not easily tamed; you need only look at the retail price index – a far more accurate measure of the real picture than the CPI because it includes housing – to see that Britain has a serious problem.
The fact is that inflation is creeping in from every direction. King and Brown maintain the current hike is mainly down to energy costs, but we are seeing price gains in everything from food and services to consumer goods. The latter is particularly significant because deflation in these items – mostly imports from China – has been one of the main factors in keeping inflation down.
The situation is by no means a disaster. We are a long way from the stagflationary conditions of the Seventies, but the pain of the early Eighties was the result of a misguided belief that a little bit of inflation wouldn't hurt. It did, and the Bank must do what it takes to ensure that this modest inflation scare remains just that.
The markets have already priced in an interest rise in May, but we're looking at a long, hard slog. The instinct is that UK rates will remain the highest among the large developed countries for a couple of years, maybe more. Prepare for higher rates – don't rule out 6% – and expect them to stay high for quite a while.
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