In his most recent open letter to the Chancellor, the Governor of the Bank of England, Mervyn King, wrote that inflation was expected to remain above its 2% target until the end of 2011. Inflation was running at 3.1% in July. The current bout of above target inflation was attributed to a series of temporary shocks: the VAT hike, energy price rises and increased import prices following a depreciation of the pound. The Governor paints a rosy picture, saying that the effects of these shocks will gradually fade away and that spare capacity in the labour market will ensure inflation returns to target. This outcome is predicted even though the Bank’s current interest rate policy, in more ordinary times, would have caused substantial inflation. The problem with the prediction is, as ever, to do with inflation expectations.
If people and businesses expect higher inflation, they demand higher wages or charge higher fees; this in turn causes inflation, which again increases inflation expectations and so on. The Bank’s interest rate is at its lowest level in three centuries. Quantitative easing has seen the Bank effectively print 200 billion pounds. Presently, most of this 200 billion is part of the monetary base and not yet ‘real money’ and so is exerting only limited upward pressure on inflation. The low interest rate and quantitative easing are signals that the Bank is not serious about tackling inflation, caring more about bolstering GDP figures.
These twin policies may be the thin end of the inflationary wedge. First, by behaving as though it doesn’t care about keeping inflation in check the Bank could well be increasing inflation expectations and so risks becoming a cause of higher inflation in its own right. Second, as the economy returns to growth, there is every possibility that the huge amount of newly printed base money will be converted into real money. This would decrease the purchasing power of each pound and cause upward inflationary pressure, particularly if combined with a low Bank interest rate. What compounds these two pitfalls is that the Bank is unlikely to act against rising inflation soon enough. The Bank’s interest rate policy has its maximum effect on inflation two years after it is enacted. If the Bank has to wait to see rising inflation before it does anything it will already be too late.