Dear George…

Mervyn King introduced himself to George Osborne last night by writing him a letter, not to wish him luck in his new and frankly unenviable role, nor to advise him on just how much austerity is needed on 22nd June to keep the markets supportive of gilts, but instead to explain why he has again overseen a rate of inflation of more than 1% above the target rate of 2%. The letter states that the Governor should:

1. Explain why inflation has moved significantly away from the target.
2. State the period within which the Governor anticipates inflation to return to target.
3. State the policy action that is being taken to deal with it.

1. The CPI index rose to 3.7% year over year in April, up from a 3.4% rise in consumer prices the previous month, and not insignificantly 0.2% above the market’s expectations for where today’s number would be. The Governor blames oil prices, the VAT increase and the fall in sterling for the inflation miss (no mention of higher duty on cigarettes and alcohol!). He believes these three factors are temporarily boosting the inflation rate and expects that inflation will fall back over time to its desired level of 2% due to the output gap. We are sympathetic with the Bank’s argument that there is a significant amount of spare capacity in the economy at present and that this will likely see inflation fall in the future.

2. Mervyn King believes that it is likely that inflation will fall back to target “absent further price level surprises…..within a year”. What a nice performance target for the year, if you are an inflation forecaster (which, thankfully, Mervyn is not): he will hit his forecast unless he is wrong.

3. The Bank of England took unprecedented action in response to the huge contraction in demand at the onset of the financial crisis with the aim of keeping inflation near target in the medium term, by which I am referring to quantitative easing and near zero interest rates. The Governor today states that in this meeting the Committee felt it appropriate to maintain the current level of stimulus in the economy, citing an appropriate balance between downside risks (spare capacity) and upside risks (commodity prices, amongst others) to inflation.

So Mervyn’s seventh letter (now to his third different chancellor) once again explains that whilst inflation is substantially higher than where he and the MPC expected it to be at this time, and whilst inflation continues to come in higher than the market’s expectations, he and the Committee are happy for the extraordinary level of stimulus to remain in the economy for now, for fear of the fall-out that would result were stimulus to be removed too soon. This is a view we here have huge sympathy with. One only has to look at the panic in the Eurozone in recent weeks to realise that the current recovery is extremely fragile. On top of this, our new government has already announced an emergency budget for 22nd June, which will surely see fiscal tightening dampening some of the inflationary effects of monetary stimulus currently in the system.

So whilst there is sure to be some heavy criticism coming from the media and other commentators about the apparent ineptitude of the MPC to correctly forecast near term inflation, spare a thought for Mervyn. First of all, whilst the MPC has got near term inflation wrong (underestimating) for the best part of the last year, its remit is to manage medium term inflation, for which it has a strong record since its independence. My interpretation of the Governor’s citing the fragile balance between ‘upside’ and ‘downside’ risks to inflation is that it is actually a balancing of near term and medium term inflation, with the former on the one hand being boosted by extraordinary policy measures and the resulting global recovery, and the latter being justified by concerns about the recovery’s persistence and strength. Perhaps he realised that the MPC was too focused on short term inflation rather than medium term inflation when it left rates too low after the dot.com crash and then had them too high from 2007 as we approached the financial crash? This is a criticism that is surely all the more cogent when directed at the ECB?

Most importantly, though, give him credit for what he has achieved. Faced with collapsing global demand, a financial system in disarray, and a freezing and contraction in the velocity and quantity of money in the economy, extreme monetary and fiscal stimulus were a necessity. The fiscal stimulus and growth of the state that resulted from the crash has meant the UK’s and most of the western world’s levels of indebtedness have risen hugely too. And the very worst case scenario in a highly leveraged world is a deflationary spiral where prices for everything are falling whilst debts still have to be repaid in full. The lesser of two evils in this case is definitely some controlled or temporary inflation to reduce the real cost of a large debt burden (not to mention that the avoidance of deflation also enables monetary policy to maintain its efficacy). And on these terms, with positive growth, positive inflation, and a recovering housing market, perhaps it is time to praise, not criticise, the MPC for its decision to embark on quantitative easing? The range of decisions we face today as an economy are inestimably preferable to the ones we could have been facing now had we seen monetary policy inaction during the crisis. Well done Mervyn, inflation above a short-term target is a result.