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Last updated: February 16, 2011 11:45 pm
Britain will have to get used to slower growth if people want to avoid rising inflation, the Bank of England said on Wednesday, as its forecasts suggested the effects of the financial crisis would linger for longer than expected.
The Bank’s more downbeat medium-term assessment in the quarterly Inflation Report comes on top of Mervyn King’s statement that household incomes are facing the worst squeeze since the 1920s.
But a combative Bank governor was certain that he and the Bank had made no mistakes over policy.
Asked what he had learnt from the Bank’s poor inflation forecasts, he said he had learnt only that “out-turns for inflation ... can be explained by unexpected increases in energy prices and commodity prices, including food prices”. Nothing about the Bank’s policy actions was at fault.
“Would you have had us deliberately raise interest rates by a significant amount in order to induce a much deeper recession, raise unemployment in order to push money wages down in the way that it has happened in Ireland and Greece and Portugal in order to meet the inflation target in the short run?” he asked a journalist.
The governor had “enormous sympathy” for people suffering a squeeze on their living standards from high inflation, but that squeeze “was going to happen one way or another – it’s the price we are all paying for the financial crisis”.
In truth, there were two Mr Kings on display on Wednesday. The one that was certain about the expediency of the Bank’s past policy was not talking to the other Mr King who wanted to talk about deep policy uncertainties.
“There is no black and white here,” the governor’s alter ego said. “These are difficult judgments and anyone who is absolutely certain that a certain course of action is right or wrong is exaggerating the degree of certainty about the future.”
Observers were left wondering which Mr King was running monetary policy.
After the latest temporary inflation shock subsides, the Bank’s report was much clearer about the challenges Britain faced in the medium term.
The monetary policy committee now collectively cites four reasons why the balance between output and inflation has deteriorated and will keep inflation higher for longer, and this partly justifies the speculation over the need for tighter monetary policy.
First, the MPC thinks companies selling goods and services in the UK are likely to seek to raise profit margins hit by sterling’s fall in recent years and higher import prices.
Second, the committee thinks the ability of the economy to supply output has been hit by the financial crisis and lack of investment, so it has reduced its assumed degree of spare capacity to “reflect a loss of underlying productivity which is likely to persist throughout the forecast and possibly beyond”.
Third, the MPC has built in a small effect from raised inflation expectations because it expects companies to raise prices and wages faster in anticipation of higher inflation.
Fourth, it expects employees to resist the squeeze in living standards and demand higher pay rises.
Charlie Bean, deputy governor, said: “There is an element of all these things in [the forecasts] which make the combination of output and inflation that we see in the second year of the forecast and into the third year somewhat less favourable.”
It is impossible to be precise about the MPC’s analytical changes because of secrecy about its forecasts for a week after publication.
Imprecise estimates from the charts in the Inflation Report suggest the Bank now believes the UK economy must grow by about 0.25 percentage points less than it thought in November to avoid sparking inflation.
That is a loss to economic output which accumulates by roughly an additional £4bn every year, making fiscal consolidation even more difficult.
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