Mervyn King's Letter To The Chancellor
The threat of stagflation provides the Bank of England with its first real test since independence.
Mervyn King's second letter to the Chancellor, explaining why inflation has risen above 3%, came as no surprise. The Bank of England governor has had his quill sharpened for weeks, and it was simple enough to explain what went wrong. The problem isn't domestic inflation, but imported inflation – the result of a 60% hike in basic food commodities over the past year and a doubling of the oil price.
The more difficult question facing King is what to do about it. The policy choice is looking increasingly polarised between allowing inflation to let rip or provoking a recession with interest rate rises.
In the event, King surprised the markets with the dovish tone of his letter. While conceding that inflation was likely to hit 4% this year, he stopped short of signalling a rate rise to bring it back within target.
The inference is that rates are likely to stay at 5%, yet the worry, if inflation continues unchecked, is that Britain's squeezed wage-earners will respond to higher prices by demanding bumper pay rises. The nightmare scenario is a debilitating wage / price spiral reminiscent of the dark days of the Seventies, when a combination of zero growth and rampant inflation led to a stagnant economy, simmering social conflicts, and governments racked by one financial crisis after another.
It shouldn't be forgotten that a key reason for handing over monetary policy to the Bank in 1997 was to see off for good the idea that workers could bid up their wages without being penalised by higher interest rates.
Wage inflation is under control but there are ominous signs that that could change. Public expectations of inflation at 4.9% are much higher that the Bank's own forecast; and if they begin to influence pay-bargaining, watch out. Recent disputes – from the Shell tanker drivers' strike to murmurings from public sector unions – are a sign that the dam could burst. If that happens, King will have no choice but to raise rates.
The concern must be that if prices continue to rocket, a wedge will be driven between the Old Lady of Threadneedle Street and the Treasury – leading to an open dispute on how to conduct policy.
Of course, it may not come to that. The hope is that the current slowdown will do the work unaided: that falling house prices and rising unemployment will depress the cost of living enough to avoid another rate hike. After the credit-fuelled excesses of recent years, we face hard times, but King's letter suggests that hangover may not be as gruesome as many feared.
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