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At some point today, the governor of the Bank of England, Mervyn King, will sit down to write a letter to George Osborne. Tomorrow sees the release of the inflation figures for January and the news will be bad. In the 12 months to December, cost of living rose by 3.7% on the government's preferred measure and the City expects 4% or more for January.

The Bank's legal task is to hit the 2% inflation target laid down by parliament and it has to explain itself if it fails in that task. If inflation deviates by more than one percentage point away from target, the governor has to write a public letter of explanation to the chancellor, and then keep on writing them once a quarter until things improve.

For the first 10 years after the Bank was given independence in 1997 inflation was so well behaved there was never a need to flourish the gubernatorial fountain pen. But since the start of the financial crisis in 2007, the quarterly letter-writing process has become something of a ritual.

It is now three months since King's last epistle, a period during which price pressures have risen but output has fallen. The Bank kept interest rates unchanged for a 23rd consecutive month last week but a minority on its nine-strong monetary policy committee – supported by an increasingly vociferous band of critics in the City – think the time has come to start raising rates.

So what will be going through King's head as he sits down at his keyboard? And what will Osborne make of the governor's explanation? Here is a highly fictionalised account of what the two men might say and some of the thoughts they are likely to keep to themselves.

Dear Chancellor,

When I last wrote to you in November, the annual rate of inflation stood at 3.2%. The Office for National Statistics will tomorrow publish figures for January showing that it now stands at 4.2% [a guess not a prediction: LE]. I am therefore writing to explain why inflation has deviated from its target and what we intend to do about it.

Our analysis has changed little since November. We believe inflation remains uncomfortably high for three reasons. Firstly, there has been a substantial devaluation in the pound since 2007. That has pushed up the cost of imports. Secondly, there has been a sharp jump in the cost of oil, food and other commodities. Thirdly, VAT has been increased as the Treasury has sought to repair the public finances following the increase in the budget deficit during the recession of 2008-09.

The 25% drop in sterling followed a long period in which the pound was over-valued, helping to cause the build-up of structural imbalances in the economy pre-2007. A substantial depreciation was overdue, inevitable given the economy's heavy reliance on financial services and the housing market, and necessary if there is to be the economic re-balancing we both think is now necessary. Those who say the Bank has done nothing to prevent the pound's fall and has, on occasions, actively talked it down, are right. But, in my view, the MPC had no alternative. Seeking to arrest or reverse the pound's fall would only have been feasible had we baulked at cutting bank rate to 0.5% in early 2009 as part of the co-ordinated global action to avoid a second Great Depression.

The MPC has no control over world commodity prices and, clearly, decisions over taxes are for you rather than for us. We think these three forces pushing up inflation will eventually blow themselves out. Sterling has stopped falling and, indeed, has started to strengthen on the foreign exchanges. We think it unlikely that commodity prices will repeat the 2010 increases in 2011, and unless you are keeping your cards very close to your chest, the prospects of a further increase in VAT next January are slim.

Inflation will come down but, unfortunately, not yet. It is quite possible that the CPI measure of inflation will hit 5% before starting to head lower in the second half of this year. I realise, of course, that this was the gist of my letter to you this time last year, when I said the MPC thought inflation would be coming back towards target by early 2011. We were, and I have to be frank about this, wrong about that. But it remains my view that we were wrong only about the timing of the fall back in inflation and not in our fundamental analysis.

The Bank appreciates that its credibility is on the line. Should inflation prove more stubborn than the MPC imagines and, in particular, were the increases in food and fuel prices to be reflected in higher wage settlements in this year's pay round we would move swiftly to tighten policy. At present, however, we see no sign of that. Pay awards remain low, average earnings are growing less rapidly than prices, and unemployment is on the rise. We could bring inflation back to target more quickly but only by deflating the domestic economy at a time when consumer confidence is weak, the housing market is becalmed, taxes have just gone up and the public spending restraint you announced last year is about to suck demand out of the economy. There is, I know, a school of thought that says the Bank should just nudge up bank rate from 0.5% to prove it is serious about hitting the inflation target. But the argument that a slight increase would do little damage to activity while augmenting the MPC's credibility seems to me a dubious one. Such a course of action would be seen by the City as an admission that we had been wrong in our analysis and that we were worried about knock-on effects from sterling's depreciation and higher commodity prices. There would be strong pressure from the financial markets for further, and substantial increases in bank rate. As we both know, debt levels in the UK remain worryingly high and many borrowers – household and corporate – remain vulnerable to higher interest rates. I remain unconvinced that a policy which kills off the economy will enhance the Bank's credibility, so I urge you and your coalition colleagues to be patient, trust us, and keep your fingers crossed that we are right.

Yours sincerely, Mervyn.

Dear Mervyn, The government is serious about the inflation target so I hope you know what you are doing. At some point, interest rates will have to rise and I hope that the Bank will prepare the ground for that carefully.

For now, though, I can see that tightening monetary policy and fiscal policy simultaneously risks tipping the economy back into recession and busting apart the coalition, so keep up the good work.

Yours sincerely, George

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The MPC has no control over world commodity prices

Its this error in thinking that is the most depressing. Of course low interest rates and the consequent liquidity has an impact on world commodity prices. Give the financial system nearly free money and watch it gamble it on commodities FTW.

At this stage in the game it is staggering that so many observers can not join the dots between low interest rates and asset bubbles.

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Its this error in thinking that is the most depressing. Of course low interest rates and the consequent liquidity has an impact on world commodity prices. Give the financial system nearly free money and watch it gamble it on commodities FTW.

At this stage in the game it is staggering that so many observers can not join the dots between low interest rates and asset bubbles.

Yep. And QEs. Including by the FED, dollars. All major currencies are going down, almost simultaneously.

Most observers think the main currencies are "stable" because their exchange rates are stable. They don't understand that all currencies can lose value at the same time. If all are doing QE, for instance. In these cases, it looks like it is the products and assets that are "going up". It is not, it is the currencies that are going down, losing purchasing power.

Usually this mistake doesn't matter, but in a few cases, it does: Commodities will not come "back down".

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