Sean O'Grady: Mervyn to TUC: I'm on your side. Sort of

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Like a comic at the Glasgow Empire performing after both Rangers and Celtic had lost at home, the Governor of the Bank of England will be lucky to escape a hostile reception when he faces the Trades Union Congress in Manchester next month. The brothers have already torn up their invitation to Vince Cable, now that he is a Tory collaborator; but they may not have forgotten Mervyn King's endorsement of George Osborne's emergency Budget (which was rather more enthusiastic than anything heard from the Business Secretary).

So Mr King will have to use his best material. His predecessor, the legendarily charming Eddie George, kicked off his address to Congress in 1998, the last time a Governor attended, by acknowledging the abuse that had been lobbed at the Bank from the left: "Some of you evidently think we're a crowd of 'pointy-heads' or 'inflation nutters', or even 'manufacturing hooligans' – and I'm not sure these descriptions are intended as terms of endearment." Steady Eddie disarmed them, even if he may not have entirely convinced them that there can be no long-term trade off between inflation and growth.

Times are tougher now, and Mr King similarly needs to reassure the TUC that he is not the enemy. This will come surprisingly easy for him. Long gone are the days when the Bank regarded itself as the shop steward of finance capital. Today the Bank sees its role as protecting the economy from the banks, and the near £1 trillion the financial crisis has cost the British taxpayer in recapitalisations, rescues, subsidies, soft loans, loan guarantees and other support is as deeply resented in Threadneedle Street as at Congress House. The Governor, let it be recalled, was one of the first to call for the "too big to fail" problem to be solved by breaking up the banks and hiving off their "casino" activities.

Like the TUC, Mr King is also keen on rebalancing the economy away from consumption and the City towards manufacturing, exports and investment. He has criticised the way that the best and brightest of graduates are sucked into financial engineering rather than the real thing, and expressed anger about the way ordinary working families and businesses have had to pay the price in jobs and closures for the bankers' mistakes. On these broad issues our central bank is not so very far away from our trade unions.

Still, Mr King will also have to be frank with his audience about the emergency Budget. This will, after all, take £113bn in spending power out of the economy over five years, and see 600,000 public sector jobs go, the vast majority occupied by union members. The unions want resistance to the cuts; Mr King, acquiescence. The TUC sees the danger of a double dip as a direct consequence of the Budget; the Governor has said the Budget itself made no significant difference to that, and it lessened the probability of a full-scale British sovereign debt crisis, with all the appalling consequences that would have had for rates and mortgage bills.

Mr King will also risk being booed off the stage if he calls for further wage restraint, though the case he can make for it is powerful. This time last year most economists feared that unemployment would top 3 million, or one-in-10 of the workforce. That's what "should" have happened if the pattern of the last few recessions had been repeated this time round, according to "Okun's Law", after the American economist Arthur Okun, who first tried to link falls in output and employment empirically, back in 1962. Based on experience in the last two recessions (1979-82 and 1990-92), many more would be on the dole now if labour markets had not become more flexible.

So the fact that jobless queues did not lengthen still further is partly down to widespread pay freezes. Workers and unions have gone along with these – but for how much longer? Especially when inflation will stay above Mr King's 2 per cent target for another year or more, according to the Bank's own forecasts. The Coalition has announced a pay freeze for public workers on more than £21,000, and not much for those below that – and all at a time when taxes are rising. Why, Mr King will have to explain, should ordinary families have to make such sacrifices when bankers' bonuses are soaring and fat-cat executives are still paying themselves enormous raises? If Mr King cannot answer that, he will surely die the death in Manchester, even if he doesn't deserve to.

Inflation? Where?

Ten-year bond yields don't usually grab the attention, but they do matter, because of what they tell us about the way the economy is likely to develop, or at least how healthy the markets think the economy is, which can amount to the same thing.

The good news here is that the lows of 2.9 per cent or so seen yesterday imply that the great inflation predicted by latter-day monetarists is unlikely to arrive. These punk monetarists have forecast an inevitable, though delayed, reaction to the £200bn the Bank has "printed" through its programme of quantitative easing to show up in an erosion of the currency. The admittedly high inflation we're seeing at the moment, by international standards, is taken as an early omen of a nastier dose of the inflationary disease later on.

The bad news is that the weakness in the economy the markets detect suggests a rather greater danger of out-and-out deflation – generally falling prices and a stagnant economy drained of confidence. That was the peril avoided after the G20 co-ordinated a massive global fiscal and monetary stimulus in the autumn of 2008 led, it must be said, by Gordon Brown. Now almost every government in the advanced world, apart from the US, is aggressively reducing public spending and borrowing, the slump that we avoided then may be about to befall us, albeit in slower motion and in a more controlled, calmer fashion. It is bad news for wages, house prices and unemployment. We can only hope the markets are wrong.

For further reading

'How Useful is Okun's Law', by Edward S Knotek (Federal Reserve Bank of Kansas, 2007)