Mervyn King and Alistair Darling have become reluctant pen pals once again. New figures showing that consumer price inflation breached 3 per cent last month have prompted the Governor of the Bank of England to write another letter of explanation to the Chancellor of the Exchequer.
Mr Darling has accepted Mr King's explanation that this jump in prices is likely to prove temporary. But not everyone has. Inflation hawks have begun to stir, pointing to uncomfortably strong levels of core inflation (excluding food and energy) in the latest statistics and questioning the Bank's assumptions about the level of spare capacity in the British economy.
These are not idle concerns. If a sizeable chunk of our productive capacity from before the recession turns out to have disappeared forever in the slump, rather than being temporarily underused, we could run into the inflationary buffers much sooner than the Governor forecasts. The hawks also note out that British inflation, in contrast with prices in other developed countries, has consistently surprised policymakers with its stubbornness throughout this downturn. Prices do seem to be "stickier" here than elsewhere.
Nevertheless, the Governor is justified in arguing that the inflationary pressures that have exposed themselves in this month's figures are likely to prove temporary. The rate of inflation will probably fall back in the coming months. The two main drivers of the increase in the headline rate – the restoration of VAT to 17.5 per cent and a spike in petrol prices – are likely to be one-off factors.
Another inflationary pressure of late has been the depreciation of sterling by some 25 per cent since 2007, which has pushed up the prices of certain imports. This too will be a one-off influence on the price level, assuming, of course, there is not a sterling crisis.
Just as important, one of the main drivers of national bouts of inflation in previous decades – rising wages – is conspicuously missing at the moment. Earnings growth has been negligible in most sectors of the economy in the past year. Indeed, many workers are still accepting pay cuts as the price of keeping their jobs. There seems little likelihood of workers demanding higher wages to compensate for an increased cost of living.
The pain inflicted by rising prices, especially for those who live off savings income, should not be dismissed. And over the longer term, the Bank does need to be alive to the danger of inflation getting out of hand. Spiralling prices at a time of weak economic growth would be a disaster for Britain. And the imminence of a general election only adds to the uncertainty with respect to the impact of fiscal policy on the economy.
But, ultimately, monetary policy-makers need to make a judgement based on the balance of economic risk. And while the risk of stagflation is real, so is the risk of snuffing out a meagre recovery by tightening monetary policy too early. Indeed at the moment, the latter risk appears the more serious.
Having decided to call a halt to quantitative easing earlier this month, the Bank has tightened monetary policy sufficiently for now. Mr King and the Bank's Monetary Policy Committee should leave policy interest rates where they are, at least until the fog of economic uncertainty begins to clear a little.