Bank of England may run twin-track inflation measures

The Bank of England may have to run two inflation measures side by side when setting interest rates under plans that are still being finalised by the Treasury.

Gordon Brown, the Chancellor, said in June he would change the Bank's inflation target from the current RPIX (retail price index excluding mortgages) to the HICP (harmonised index of consumer prices) "at the time" of the November pre-Budget report.

But Mervyn King, the Bank's new Governor, last week cast doubt on the wisdom of switching the target in November when the two measures would still be miles apart.

The latest figures showed there was a gap of 1.6 percentage points in July, close to the widest apart the two measures have been since HICP was launched.

The Treasury acknowledges there are logistical problems with managing a changeover and is currently looking at several options.

One would be to set an HICP target and instruct the Bank to target that when setting interest rates, but to retain RPIX for the letter-writing system under which the Bank must publicly explain why it has missed the target by a certain amount.

Analysts believe the Chancellor will set a HICP target of 2 per cent with a 1 percentage band either side - something that is quite likely to be missed in November.

Another option is to announce the target but suspend its operation until a set date. An alternative would be to suspend the letter-writing system for two years - the period economists believe it takes for rate changes to feed through.

This would be a convenient option as the Bank expects house-price inflation - a key reason behind the split between the two measures - to fall to zero in two years' time. Mr King pointed out that HICP had been below 2 per cent for the last two years - a time when the housing market was booming.

Meanwhile, Charlie Bean, the Bank's chief economist, yesterday said central banks needed to make a "shift in rhetoric" to explain how concerns about financial imbalances such as house-price booms and debt bubbles feed into their decision. In a speech that was mostly identical to one given in March, Mr Bean said: "Financial imbalances, asset price misalignments and the instability that may result as they correct may pose significant problems for monetary policy makers."

And in a new sentence added since March, he said: "Taking on board the possible risks posed by cumulating financial imbalances may require a shift in the rhetoric of inflation targeters towards the longer term."

Economists in the City believe the Bank's Monetary Policy will have problems presenting its policy decisions once HICP comes in force.

Stephen Lewis, chief economist at Monument Securities, said: "Far from being a good time to make the switch in targets, this is one of the worst times ever. The risk is that the MPC in November will have to ignore the new HICP target, thereby undermining it from the outset."