So the letter finally arrived. The Governor of the Bank of England- Mervyn King - had to openly admit that the Bank of England had failed to meet the 2 percent inflation target.
This letter writing thing is a little strange. Since the beginning of 2006, inflation has been systematically above 2 percent. However, 3 percent is the magic number that generates a frank admission that there is a problem.
So what does the letter say? As expected, it starts with a long and predictable exercise in blameshifting. The causes are many and various; food, oil, global demand, global supply, domestic gas and electricity prices, and the depreciating exchange rate. In fact, it is everything but the policy decisions of the MPC. Their decision to keep interest rates too low for too long doesn't get a mention.
The excuses are shameless. These factors, of course, have only short term temporary effects on inflation. Many of these problems have turned up quite recently. The data shows that the inflationary problems have been building since at least 2006. For example, over well over two years the RPI has been above 4 percent (see chart above).
The real reasons for today's higher inflation rests with the MPC. The UK has a floating exchange rate; which means monetary policy and therefore the price level, is firmly under the control of the central bank. If the MPC wanted to reduce inflation, all it had to do was raise rates. However, it chose not to, and now we have inflation.
The governor follows his lame excuses with the key question - how long will inflation stay above 3 percent? He raises the question, but doesn't really answer it. He merely says that inflation will peak at the end of the year, which sounds a lot like "the inflation numbers are going to a lot worse". He then predicts that inflation will stay above target for most of 2009. However, he does assure us that inflation will reach 2 percent. There is, however, no time frame for delivering that assurance.
Then, we come, the policy response. So far, the response to this higher inflation has been three interest rate reductions. Taken by itself, this response appears to verging on insane. However, the governor explains that the rate cuts were part of a risk balancing exercise; where the bank weighed higher inflation with slower growth. In retrospect, the balancing act appears to more like stumbling around in the dark; inflation has risen dramatically while the economy is still slowing.
As for future policy responses, the governor seems to be adrift. The interest rate path necessary to achieve the 2 percent target is "highly uncertain".
Uncertain? I can tell you right now what the level should be; a 6 percent base rate. A couple of hefty hikes within the next few weeks, and we can be guaranteed of having 2 percent inflation by next spring.
In sum, the letter had a few simple messages. First, it wasn't the MPC's fault and offered a totally unconvincing defence. Unfortunately, the data accuses the MPC of persistently showing weakness and a lack of determination in the face of growing inflationary pressure. Second, we should expect even more inflation over the next two years. Finally, the letter confirms what we all know about the MPC; it isn't quite sure what it should do, other than perhaps, keep "balancing the risks".
Unfortunately, inflation is not the kind of problem that compromises with central banks that spend their time "balancing the risks". Inflationary expectations are rising, sterling remains weak, and the central bank's response looks confused. In other words, we should expect many more years of high and persistent price increases, along with a lot more letters from the governor.