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Letter from a governor

17th June 2008 |

So, it's official and not unexpected. The consumer prices index (CPI) rate has risen above three per cent. Following last month's jump on the rate from 2.5 per cent to three per cent, all margin for error was removed and any further increase was set to force governor of the Bank Mervyn King to write a letter to the chancellor Alistair Darling explaining how the monetary policy committee (MPC) would respond.

With the news today that the rate has now hit 3.3 per cent, that letter was triggered. Responding to the news of the development, Global Insight chief economist Howard Archer predicted that this would not be the only one.

He said: "This would almost certainly be the first of several letters, as consumer price inflation looks well set to reach four per cent this summer before starting to fall back late in the year."

Mr Archer is not alone in this prediction, as yesterday the Confederation of British Industry (CBI) forecast that there will be four successive months in which Mr King will have to write an open letter. The CBI stopped slightly short of tipping the rate to hit four per cent, predicting instead a peak of 3.8 per cent.

The question investors will inevitably ask is whether the cost of borrowing will be forced back up. The MPC, as its minutes and inflation reports this year have indicated, is trying to walk a tightrope between a situation where inflation rises too high and one where it eventually undershoots the target due to tight a monetary policy that restricts already weakening economic growth.

In his letter, Mr King himself concurred with the notion that CPI may rise to four per cent and that he will be writing several letters. His explanation for the price rises of the last few months and for the likely ones ahead was mainly the increase in cost of food, petrol and domestic energy, along with the rising cost of imported goods caused by the depreciation in the value of sterling. That much is nothing new, for as Mr King pointed out these same influences were highlighted in the May inflation report.

Mr King did not commit the MPC to increasing base rates, noting that the remit of the body's task did state that a knee-jerk response to sudden or temporary "shocks and disturbances" could bring about "undesirable volatility in output".

While this may amount to a get-out clause absolving the MPC from any strict requirement to raise rates, the door to such a move was also left open as Mr King stated: "The path of Bank rate that will be necessary to meet the two per cent target is uncertain." He pledged that, as ever, the MPC would consider what needed to be done on a month-by-month basis.

However, the view of the CBI when it made its prediction yesterday was more upbeat. Rather than forecasting any rate rises, it suggested the MPC would instead be deterred from any further rate cuts until the first half of 2009, when two rate cuts will take place to bring the base rate down to 4.5 per cent. Those hoping for the cost of borrowing to ease to the benefit of the property market may hope that such a prediction turns out to be right.