Everyone agrees the main aim of Labour’s Bank of England was to get inflation down to 2% and keep it there. Most also agree that the Bank has been singularly unsuccessful at doing so.
Inflation as measured by the last government’s second choice of target, the CPI, surged to 5% in 2008. It has been above 2% for most of the last three years, often by a significant margin. Throughout that period the Bank has published fan charts showing inflation coming down quite quickly to the 2% level or below. The Bank has usually argued that the prospect is finely balanced between an overshoot and an undershoot. So far it has always overshot.
The Bank has argued that much of the inflation has been “imported” and so not so susceptible to control by changes in domestic interest rates. However, the period is characterised by a major devaluation of the pound. By the end of 2008 the pound was around one quarter below its 2007 highest levels. The surge in world commodity prices at the end of the last decade did not induce the same big increases in inflation in Euro and US markets that it helped induce in the UK. Subsequent falls in many commodity prices did not get UK inflation back down to target. A devaluation may well have something to do with the quantity and price of money.
The Bank in its defence is right to point out that the UK has not suffered a wage/price spiral in recent years, so inflation has not soared above the 5% level. It is right that fighting recession requires looser money anyway – the problem with that argument is they did not deliver it at the right time as we discussed before.
The Bank is trying to control price rises in an economy which is vulnerable to import prices on weaker sterling, vulnerable to energy and raw material prices, and vulnerable to state price rises and tax rises as the government battles to get the deficit down by increasing state revenues.
If the bank had moved interest rates higher in 2005-6 it would have curbed the inflation that broke out, and would have restrained some of the excess credit creation that followed. If the government had not run such a large deficit before the recession boosted spending and cut taxes, that too would have helped keep price rises under control and would have given the state more flexibility in the downturn. If the government did more deficit reduction by controlling costs in the public sector, and less by pushing up taxes and charges on the private sector, that too would cut the inflation rate.