A small price to pay
The CPI measure of UK inflation was 3.7 percent in April - its highest for 17 months. The governor of the Bank of England - Mervyn King - while nominally independent of the government - is obliged to write an open letter to the Chancellor of the Exchequer, whenever inflation is over a percent away from the target level of two percent
One of the Bank of England's big jobs it to try to keep UK inflation as close to two percent as possible. Its main tool in achieving that aim is interest rates as, in theory, the cost of borrowing money has a direct effect on demand, which in turn has a direct effect on prices.
The banking crisis of the past two years has seriously threatened the inversely proportional relationship between inflation and interest rates for a couple of main reasons. Firstly, the banks cocked things up so badly that they're now more concerned with repairing their balance sheets than competing with each other for new loans. This means the lowest interest rates ever aren't being passed on in full to borrowers.
Secondly, having dropped interest rates pretty much as far as they will go, the B of E can no longer use them as an instrument to boost a flagging economy. Conversely, while the economy continues to flirt with recession, the B of E will be reluctant to increase interest rates regardless of inflation, and risk suffocating what anaemic recovery we have managed. Hello stagflation.
In his letter King, who has already publicly endorsed the immediate commencement of deflationary public sector cuts, blames the high level of inflation on three factors, none of which are a consequence of excessive demand, and which he thinks will correct themselves in due course. They are: high oil (and hence petrol) prices, the restoration of the 17.5 percent VAT rate and the weakness of the pound (which makes imports more expensive).
He says the B of E's projections have inflation naturally falling back to, and possibly below, the two percent target within a year, thanks to the deflationary effects of the continued ‘spare capacity' (i.e. underused productivity). The letter reads very much like a justification for keeping interest rates low in spite of above-target inflation, with the knowledge of the austerity measures to come very much in mind.
In his public response, new Chancellor George Osborne says the Treasury's own compilation of independent forecasts has inflation at 2.1 percent in Q4 2010 and 1.7 percent in Q4 2011, so he agrees with King's mid-term prognosis. He also stressed that his overriding priority is to reduce national debt by making public sector cuts and thanked King for his public support for those plans.