June 23, 2008	Monday	Jamadi-us-Sani 18, 1429

The rising trend in the rate of inflation in the UK has become so worrisome that Mervyn King, the Governor of Bank of England, was forced last week to write the mandatory letter to the Chancellor of Exchequer, Alistair Darling, explaining why inflation has moved more than one per cent above its target of two per cent and how he wants to bring it back to target. He has also said how long the rate is likely to remain above target.

It is likely to be the first of a series of at least three such letters. Possibly more letters are written every three months if inflation remains above target.

Indeed, Mr King devoted a large part of his letter to emphasise that the upward pressure on inflation seen since the end of last year has reflected global increases in food and energy prices and was likely to be temporary. He stressed that there is “no generalised rise in prices and wages caused by rapid growth in the amount of money spent in the economy”.

He also appeared to dampen speculation that interest rates might soon rise by stating that the monetary framework recognises that external shocks could take inflation away from target for a period and that setting Bank Rate to bring it back to target quickly would result in “unnecessary volatility in output and employment”.

He made it clear that inflation is now likely to go higher than predicted in May’s Inflation Report, probably rising above four per cent in the second half of the year. Moreover, he stressed that “it is crucial that prices other than those of commodities, energy and imports do not start rising at a faster rate”.

Nonetheless, the message appeared to be that the markets have become too pessimistic in pricing in several interest rate hikes this year.

The fact that the Monetary Policy Committee of BoE discussed the case for an immediate rise in interest rates at its June meeting is another worrying development for the outlook for the economy.

The minutes of June’s MPC meeting might reverse some of the drop in market interest rate expectations seen after Mervyn King’s “dovish” inflation letter. Although, as expected, the committee voted 8-1 to leave rates unchanged at five per cent, some members considered whether an immediate rise in rates was warranted.

Admittedly, the idea was fairly firmly dismissed on the basis that medium-term inflation expectations remained well anchored and that credit constraints and higher yields were dampening demand.

At the same time, the committee conceded that further significant falls in house prices were probable and that anecdotal and survey evidence on household spending was very weak. It also concluded that the relative strength of bank lending partly reflected the drawdown of committed credit lines in response to the cost, and lack of availability, of other forms of credit.

Nonetheless, the committee reiterated its view that a fairly significant slowdown in the economy is necessary in order to bring inflation back to target over the medium-term. It also judged that the risks to the inflation outlook had “moved further to the upside”. The data released since the meeting, including the rise in CPI inflation to 3.3 per cent, may have strengthened this view.

Alistair Darling, the Chancellor in his reply to the Governor’s letter agreed with most of what King had penned.

He was in accord with King that in the year to May world agricultural prices increased by 60 per cent and UK retail food prices by eight per cent; oil prices rose by more than 80 per cent to average $123 a barrel and UK retail fuel prices increased by 20 per cent and; wholesale gas prices increased by 160 per cent and UK household electricity and gas bills by around 10 per cent.

Darling said: I agree with your (King’s) assessment that pay growth has remained moderate. Average earnings growth, excluding bonuses, in the year to April was 3.9 per cent, a little below its average since May 1997. Continued restraint on pay is required from both the public and private sector and that is why the government has agreed a number of multi-year pay deals covering 1.5 million public sector employees. To return now to inflationary pay settlements would undermine rather than raise people’s living standards with a damaging circle of wage increases eroded by steadily rising prices.

“You emphasise the likelihood that, while the pick-up in inflation should be temporary, inflation will remain markedly above the target until well into 2009.”

Alistair Darling also warned trade unions against a “disastrous” return to 1970s-style inflationary pay demands, after striking Shell tanker drivers secured a big wage settlement amid threats of renewed unrest in the public sector.

The chancellor raised the danger of a wage-price spiral gripping Britain, where “imported” inflation in the shape of rising energy and food prices is reinforced by domestic pay pressures.

“If you get yourself into a position where every extra penny you get through pay rises is eaten up through price rises, through inflation, then we will get into precisely the problems Britain had in the 1970s, 1980s and even the early 1990s,” Mr Darling told the BBC.

“We have got to be vigilant in relation to all pay – public and private sector pay alike – because if we get ourselves into that spiral, it will take years to get out of it.”

Meanwhile, the Confederation of British Industries said the UK economy will grow next year at the weakest pace since the early 1990s as higher oil prices squeeze corporate profits and household budgets. The CBI said it expected growth of 1.7 per cent in gross domestic product this year. The CBI did not predict an outright recession. Richard Lambert, director-general, said that in spite of a worsening outlook: “Our best bet is still that there will be a measure of economic growth in 2009. We should avoid believing a recession is inevitable or talk ourselves into unnecessary trouble”

He said companies were now more efficient and the economy more global than in the 1990s, when consumer demand plunged for a sustained period and job losses spread across the country. “We should avoid believing a recession is inevitable or talk ourselves into unnecessary trouble,” he added.