View from City Road: Bank of England is right to be wary

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Government hopes of hitting and sticking to its target of 1 to 2.5 per cent underlying inflation by the end of the Parliament depend crucially on the performance of the labour market, long the Achilles' heel of the British economy. If the Bank of England's quarterly Inflation Report is any guide, the omens are not good. Average earnings in the year to February rose 3.5 per cent. The Bank believes March could bring a further acceleration. According to the Bank, the Chancellor of the Exchequer has only himself to blame. By ignoring the Bank's advice and cutting interest rates by a quarter- point in February, he has cast doubt on his desire to secure low inflation among both pay negotiators and dealers in the markets.

The Bank finds itself in a catch-22 situation. If it berates the Government for being soft on inflation and publishes disturbingly high forecasts, then this in itself can damage confidence and exacerbate the upward pressure on inflation and inflationary expectations. In the past the Bank has shown an unfortunate tendency to overestimate future inflation.

The Bank is none the less right to warn about the stirrings in the labour market. Like many City economists, it believes that the Central Statistical Office is underestimating the strength of the recovery. In those circumstances employees might well try and compensate both for higher than expected inflation and the effect of tax increases by asking for better pay deals.

The uncomfortable truth is that if the Chancellor is to avoid making matters worse, he will have to give up all hope of another cut in interest rates. Given that interest rate changes take two years fully to feed through to inflation, it is looking increasingly likely that rates will have to go up before the end of the year if there is to be any hope of hitting the inflation target.