The Bank's intensifying dilemma

By Hugh Pym BBC economics editor

Rising food prices have contributed significantly to inflation

There is something a little unreal about the fact that while a global financial crisis is raging and the UK teeters on the brink of recession, the inflation threat remains as potent as ever.

In normal circumstances, rapid and deep cuts in interest rates would be a near certainty. The prospect of negative economic growth and a knock to household wealth in the shape of plunging share prices would be enough for the Bank of England to loosen the reins with alacrity.

And therein lies the Bank of England's continuing and intensifying dilemma.

Inflation, measured by the Consumer Prices Index (CPI), has once again risen more than expected, to 4.7% over the year to August compared with 4.4% the previous month. The familiar roll call of villains played their part - soaring food, oil and utility bills.

Warning tone

The governor of the Bank of England's letter to the chancellor sheds some light on the latest thinking in Threadneedle Street.

Mervyn King underlines the global factors which he says "have temporary implications for inflation". These include a surge in world food prices by 40% in the year to August and wholesale gas prices up 90%.

The overall tone of his letter is that he and his colleagues are focusing firmly on inflation, whatever financial market storms are raging beyond Threadneedle Street

He says CPI inflation is expected to peak soon at about 5% and that it will fall sharply as the impact of energy and food price rises falls away. The Monetary Policy Committee (MPC), says Mr King, "expects inflation to fall sharply in 2009 and� back to target thereafter".

Thus far a reassuring message from the governor's parlour. But read on and there is a starker tone, particularly for those hoping for an interest rate cut sooner rather than later.

The governor argues that the impact of inflation on price and wage pressures "may be larger than currently envisaged by the MPC". This could result in a longer period of inflation well above target and higher inflation expectations for households.

Rate cuts?

Mr King highlights again the danger of elevated wage demands and settlements fuelling inflation. He argues, crucially, that the risks of a wage and prices spiral developing are now greater than they were.

His conclusion is that "the Committee has become firmer in its belief that a period of muted economic growth is necessary to dampen pressures on prices and wages and return inflation to the target".

In other words, there may be two quarters of negative growth (so technically a recession) but don't expect cuts in interest rates until we are certain the inflationary threat has passed.

The governor concedes that the MPC will look at all the latest developments, "including those in the financial markets" at the next monthly meeting. But the overall tone of his letter is that he and his colleagues are focusing firmly on inflation, whatever financial market storms are raging beyond Threadneedle Street.

Interest rate cuts seem likely to come at some stage. Today's message from the Bank is don't expect anything in a hurry, however painful that may be for the housing market.

E-mail this to a friend

Printable version