King warns of inflation volatility

Economy: Bank's new Governor tells MPs that decade of unprecedented stability is coming to an end

Britain is headed for a period of volatile inflation as a decade of unprecedented economic stability comes to an end, the new Governor of the Bank of England warned yesterday.

Mervyn King, giving his first public appearance since taking on the job on 1 July, told a committee of MPs the UK was set for a major rebalancing that would not be "entirely easy to manage".

His comments came as official figures showed inflation dipped unexpectedly last month, opening the door to further cuts in interest rates.

Meanwhile, his new deputy, Rachel Lomax, launched a veiled attack on Government proposals to use taxes to control the economy if the UK joined the euro.

Mr King used his appearance before the Treasury select committee to flesh out a vision for the Bank's work under his governorship. He laid out three key challenges: keeping inflation close to target; curbing the risk of a UK financial crisis; and contributing to international efforts to set up a new framework to prevent and cope with global shocks.

He said the monetary policy committee (MPC) had been more successful than even the Bank had expected in keeping inflation within a range of 1.5 to 3.5 per cent for more than five years. But this had been achieved in recent years only by cutting rates and building up "significant imbalances" within the economy, he said.

"Over the next five years, these imbalances are likely to unwind," he said, saying resources would switch from the private to public sectors as "unsustainable" levels of consumer spending slowed. "Such switches in spending between different sectors of the economy could mean more volatile inflation in the short run. It won't be entirely easy to manage."

Mr King used his testimony to stress he would not seek to emulate Alan Greenspan, the chairman of the Federal Reserve, who is seen on Wall Street as being the sole voice of US monetary policy.

"As far as possible we would like people to focus on the committee. I helped put the framework in place. I believe in it and I don't want to change it."

Mr King is undertaking a review of the Bank's management, delegating responsibilities to his deputies, Andrew Large and Rachel Lomax.

Ms Lomax, a former civil servant who succeeded Mr King as deputy governor for monetary policy on 1 July, said there was little danger of the Governor dominating an MPC that included "strong minded people". On monetary policy Ms Lomax voiced worries about the build-up of debt on the back of recent rate cuts, and also flagged up concern over the global outlook.

Asked what kept her awake at night, she told MPs: "Anyone with my experience is going to be worried about debt and the housing market and I think there is a worry about the world outlook - in Europe as much as, more than possibly, the [United] States."

She was also concerned about the danger of making policy errors, adding: "I have been involved in policymaking in periods when it turned out we were wrong."

Ms Lomax, who worked at the Treasury between 1968 and 1994, was sceptical about using the output gap - the difference between actual and potential growth - to set policy.

She was asked about the Government's proposal, published with last month's decision on euro membership, to set a target for the output gap that would allow it to order tax hikes or cuts to control the economy in the case of a shock.

"Experience has made me cautious about pinning policy decisions too precisely on measure such as the output gap," she told MPs.

"Major policy errors were committed when the measure of the output gap was something very different from what it turned out to be."

Both were keen to avoid giving clues on short-term interest rates ahead of the publication of the minutes of last week's MPC meeting that culminated in the surprise rate cut.

The markets instead focused on a fall in inflation last month. The Government's target rate slowed to 2.8 per cent from 2.9 per cent in May. Analysts had predicted a rise to 3.0 per cent.

Andrij Halushka, an economist at the Centre for Economics and Business Research, said: "With today's news we expect the Bank to make at least one more rate cut before the end of 2003."