An inflammatory letter reissued from June

In June I wrote about inflation. Today the same is true, but we now know that commodity prices are falling as suggested in the draft letter below:

“The Governor may soon have to write a letter to the Chancellor apologising for the high rate of inflation and saying what if anything he needs to do about it. In a way it should be the Chancellor writing to the Governor, as the Treasury has been at the bottom of the economic mistakes that have led us to higher inflation, and the Treasury has had more power than the Bank in many of the important matters which guide our economy.

The Governor, in an honest letter, would say:

“Dear Chancellor,

I am writing to report that inflation is now above 3%. This has come about because we held interest rates too low in the period 2004-6, allowing a credit bubble to emerge. The government’s decision to switch target from RPI to CPI made our task more difficult, as the CPI at the time was lower than the RPI, and has since proved to be a very poor indicator of the overall inflation people are experiencing in their daily budgets. Indeed the gap between RPI and CPI has got larger, meaning our failure on inflation as measured by the old target is worse. We felt we had to respond to a lower, easier target once set.

The government’s love of PFI/PPP off balance sheet liabilities and its rapid expansion of public spending and borrowing made conditions far looser in credit markets than was desirable, but we did not feel we could take full action to offset the government’s own wish to expand borrowing so rapidly. We felt the Treasury clearly had good policy reasons for wanting to increase public sector costs and the size of the public sector as much as it did. It was not for us to try to throttle the economy with very high interest rates to offset this huge public sector expansion. I accept that this was wrong in retrospect.

We were also wrong to keep the markets so illiquid in August and September last year leading to the run on Northern Rock. Our options have now been narrowed by the decision to nationalise Northern Rock. This has proved expensive to the taxpayer, boosting public spending still more, and has meant thanks to EU competition law that we are having to run down a leading mortgage bank at a time of mortgage famine and credit squeeze.

What should we now do? The Bank’s options are very limited. If we chase the historic inflation with higher interest rates we will make the credit crunch worse, and cause a sharper slowdown or a recession which seems a bad idea. If we take no action commentators may well say we are neglecting the high and persistent inflationary problem. This is mainly the result now of excess liquidity elsewhere in the world creating strong upward pressure on commodity prices. There is little sign of this spilling over into wage increases at home which would give another twist to the inflationary spiral. In due course it is quite possible the speculative froth in commodities will be corrected and ease the inflationary impact.

However, it is unfair that all the pressure of adjustment to harder times is currently falling on the private sector, with housing and property at the eye of the storm. I am very conscious of the government’s ambitions and high targets for new housebuilding, which are currently unrealistic. If the government wishes to rebalance the economy and ease some of the unreasonable pressure on property and finance it needs to reduce its own claims on the economy. I suggest the government redoubles its efforts, begun with the Gershon Report, to eliminate waste and less desirable spending from the large public sector, to help the adjustment . I would be happy to assist with this process, and can see many easy targets.

Yours etc”

An honest Chancellor would write back:

“Dear Governor,

Thank you for your letter. I agree we have made mistakes together, and we need to reform our system for inflation control. I wish to discuss with you strengthening the role of the Bank in managing the money markets by restoring powers to you to monitor the clearing banks day by day and to run the government debt. Like you, I now realise the Northern Rock decisions were not well made, and we need to be careful how quickly we run the business off.

The government is concerned about the state of the housing market. We see now that getting prices down to make housing more affordable does not allow more people to buy if the mortgage market has dried up. Nor does it help if people generally decide to sit tight rather than change their houses, as it limits choice and increases the number of families living in less suitable accommodation.

It will not be easy with colleagues, but I do see the force of your argument that too much of the adjustment is being taken by the private sector in general, and by the property and mortgage sector in particular. I think there is scope to reduce public spending without in any way damaging services. You are right in hinting that public sector efficiency and productivity can and should be raised. I will take your letter to Cabinet along with spending suggestions the Chief Secretary has been preparing on a contingent basis and see what we can achieve.

I agree with you that putting up interest rates now would be an inappropriate knee jerk response. I just hope you are right and that commodity prices start to subside. It will be uncomfortable to live through much more of this commodity boom, but I see no alternative that is less damaging to UK jobs and output.

Yours etc”