Jeremy Warner's Outlook: Bank vows to bring inflation under control, but it may be too late for the Government

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The Independent Online

Mervyn King, Governor of the Bank of England, will have to get used to the art of letter-writing. He's now had to pen two open letters of explanation to the Chancellor on why inflation is so much ahead of target and expects to write several more before the present spike subsides.

Yet far from provoking the Chancellor's wrath, the two men seem to be in complete harmony as to explanation – outside the Bank's and the Government's control – and even the solution, which broadly summarised is let's just carry on as we were.

What with the credit crunch, Northern Rock, and the fast-slowing economy, the Bank and the Treasury have not seen eye to eye on very much over the past year, but, on inflation, they both sing from the same hymn sheet. It's nothing to do with the Bank of England, you understand, still less the Government-imposed framework under which the Bank pursues monetary policy.

Rather, it's all down to those pesky oil and food prices. So said the Chancellor in agreeing with the Governor's letter. Both the Chancellor, Alistair Darling, and the Governor are pleased enough to accept external forces as a reasonable excuse for the apparent failure in policy to keep inflation under control.

Yet whatever he says in public, underneath it all the Chancellor must be seething. Whether it is the Bank of England's fault or not, rising inflation is part of a catalogue of economic woes which threaten to lose the Government the next election. For the time being, both the Bank and the Treasury are able to say that, though inflation might be bad, it is not quite as bad as they've got in America and Europe.

Unfortunately, even this fig leaf is about to be ripped away. As Mr King admitted in yesterday's letter, inflation is expected to rise further in the second half to more than 4 per cent. On the old RPIX measure, it is already at 4.4 per cent, or a full 1.9 per cent above the RPI target level of 2.5 per cent.

The way things are going, the Government's oft-repeated boast of the lowest inflation and highest growth in the G7 is about to be cruelly reversed. Instead it will be the lowest growth, highest inflation, and, to make matters worse still, the worst public finances. In 11 long years of New Labour rule, no Tory shadow has yet possessed such powerful ammunition to throw at the Chancellor.

The Treasury and the Bank of England were only too happy to take the credit for low inflation when factors outside their control – the deflationary effect of Asian development – caused it to be subdued. But now that the tables are reversed they are equally keen for these "global imbalances" to take the blame.

Richard Lambert, director general of the CBI, seems to have been misquoted when he accused the Government in a newspaper interview last week of having "lost it", but, whether he said it or not, it sums up the prevailing view.

Is there anything the Bank of England can do to regain the initiative? It was impossible to tell from yesterday's letter where interest rates might head.

Some interpreted the Governor's comments as dovish, others as quite hawkish. London's Evening Standard covered itself both ways with a headline on the front page which said "No rate cuts for a year", and another inside which said "King rules out rate rise". So there you have it. Mr King is so much at a loss that he doesn't know whether to put interest rates up or down.

As I say, the letter can be read both ways. On the one hand, Mr King now admits that inflation will rise to above 4 per cent and remain markedly above target until well into next year. This is quite a bit worse than Mr King was suggesting only a month ago in the May inflation report, and might suggest that policy needs to be tighter than projected back then to return inflation to target.

Mr King also says in his letter that the Monetary Policy Committee aims to return inflation to its 2 per cent target within its normal forecast horizon of about two years. This too is at odds with the May inflation report, in which inflation is forecast to remain above target until well into 2011. Again it would seem to imply interest rates need to be higher to bring inflation back to target sooner.

Yet on the other hand, Mr King says he won't take the action necessary to bring inflation back to target within the next 12 months as this would result in "unnecessary volatility in output and employment" – for which read a nasty recession. Combined with the observation that wage pressures remain subdued and the belief that there is not a whole lot that can be done about rising energy and food prices anyway, this would suggest a more moderate, or dovish, approach to interest rates.

Whatever. The bottom line is that, for the time being, the Bank of England has lost control of both inflation, and, because of the credit crunch, interest rates too. As mortgage holders have discovered, it doesn't seem to matter any longer where the Bank sets interest rates. The cost of money is going up anyway.

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