The BoE’s inflation letter to Alistair Darling

Mervyn King correctly assessed inflation risks to be temporary and the downside to come from the real economy. It sounds like he is not hawkish. Chances of a rate cut are down now. I believe the BoE wants some inflation to help do the dirty work of reducing the huge debt loads amongst British consumers and bringing down real property prices.

“If the scale of the surge in inflation caught the City by surprise, the real revelation was what Mr King had to say to Alistair Darling, the chancellor of the exchequer. The governor is obliged to write such a letter to Britain’s finance minister if inflation strays from the target by more than a percentage point. Mr King had to explain why the overshoot has occurred, and—more to the point—how he and his fellow rate-setters on the bank’s monetary-policy committee (MPC) intend putting matters right. Would the governor signal higher interest rates as the markets have been expecting? Or would he dampen those expectations?

The City swiftly interpreted Mr King’s message as dovish. In one sense this was rather odd since the governor had more bad news to impart. When the Bank of England last published its forecasts for the economy, a month ago, they showed consumer-price inflation rising to 3.7% by the end of 2008 and staying close to that rate in early 2009. In his letter, the governor raised this gloomy prediction still further, saying that inflation was likely to rise above 4% in the second half of this year, as a result of further rises in energy costs over the past month.

Mr King blamed the surge on inflation on global factors, pointing out that higher food and energy costs accounted for almost all of the 1.2 percentage points increase in consumer-price inflation since December, when it stood at 2.1%. But he said that there were good reasons to expect the period of above-target inflation to be temporary since there “there is not a generalised rise in prices and wages caused by rapid growth in the amount of money spent in the economy”. Provided that oil and commodity prices stabilised, inflation should begin to fall back to the 2% target after peaking around the end of 2008.”

–The Economist, 17 Jun 2008

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Inflation set to rise sharply this year, Bank of England governor says, The Guardian, 17 Jun 2008
Some rare sense from the Bank of England, MarketWatch, 17 Jun 2008
U.K. inflation now running at 3.3% annual clip, MarketWatch, 17 Jun 2008