February 16, 2011 10:07 pm

The difficulties of Mervyn King

It is not a gratifying time to be a central banker

“Only time will tell. The judgments are difficult.” Mervyn King, Bank of England governor, was on the defensive as he presented the Bank’s inflation report. With output sputtering and prices speeding up, it is an unpleasant time to be sitting at the interest rate controls.

Market commentators this week focused on the language of Mr King’s letter to the chancellor of the exchequer explaining the high inflation rate. In words echoed in the inflation report, Mr King said the risks of inflation either exceeding or falling short of the target were balanced, assuming that rates move as markets currently expect. Some took this as a tacit endorsement of those expectations, which price in a rate rise by May.

Mr King was keen to reject this notion. He was right to do so. The Bank takes its decisions month by month, and so great is the current economic uncertainty – and the divisions within the monetary policy committee – that everything can change in three months. Much depends on the next growth numbers – but just as one should not make too much of the fourth-quarter contraction, nor should a good first quarter alone scare the Bank into stepping on the brakes.

Recent developments have made the Bank adjust its outlook: it now expects more inflation and less growth in 2011 than it did before. It puts this down to less rosy estimates of spare capacity and second-round inflation effects. This smacks a little of post-hoc rationalisation. But there are reasons why the output-inflation trade-off may be worse than previously believed.

One is that markets are increasingly suspecting the Bank of asymmetric bias. If the monetary policy committee will do more to prevent prices from rising too slowly than from rising too fast, it is rational to expect inflation to exceed two per cent over the long term. Another is the danger of underestimating the effect on inflation of the end of deflationary pressures from China in the previous decade.

These are long-term worries. For the short term, the Bank is justified in its claims that the inflation overshoot can largely be put down to tax increases, energy costs and the fall in sterling – all factors of a one-off real income squeeze that monetary policy cannot prevent.

Largely beyond the Bank’s control, however, is whether workers will accept their real wage erosion or trigger a price-wage spiral. In a still-depressed economy, monetary policymakers must hope that those without jobs restrain the demands of those in work. There are many who are facing a more uncomfortable time than Mr King.

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