Bank of England still concerned about low pay growth and spare capacity in UK economy

The Bank of England, as expected, announced this morning that CPI inflation had rose in January to 3.5%.  On the face of it, this may seem alarmingly high, but every economist worth their salt expected this, and there was a significant minority who expected the figure to be north of 4%.

Despite the inflation figure being widely discussed two days ago in the mainstream press, newswire journalists couldn’t resist a racy headline this morning, giving the impression that the number was a bit of a surprise, which it was not.

Since the Bank of England’s official target for inflation is 2%, the Governor of the Bank of England, Mervyn King has written, once again, to the Chancellor explaining why inflation is way off target.  The answer from the Governor was simple.  A combination of rising oil prices in 2009, weaker Sterling over the past three years, historically low interest rates, an increase in VAT (Value Added Tax) from 15% to 17.5%, and some £200 billion of cash pumped into the economy was playing havoc with short term inflation figures.  “…in the short run, other factors, which cannot immediately be offset by monetary policy, can cause measured inflation to move around. Over the past three years inflation has been much more volatile than in the preceding ten years, reflecting an increase in size and frequency of these short-run factors,” the Governor stated this morning in his letter to the Chancellor.

Fortunately, the Governor of the Bank of England, and the rest of his team, do not set interest policy just on month by month figures. Instead they take a more medium to long term view on inflation. This view has changed little in recent months. The UK economy is still weak, and as long as it is, the medium term outlook on inflation is still downwards. For this reason, interest rates are going nowhere fast, and while the £200 billion asset purchase program is currently on hold, it is still feeding its way through the economy.  

“The direct effect of the short-run factors on inflation should be only temporary. Thereafter, inflation
will be determined by the growth rate of nominal spending relative to the supply capacity of the
economy,” the Governor further noted.

Mr. King went on to note that the UK economy still had a “substantial margin of spare capacity”, and noted the pay growth has remained weak. “…intelligence from the Bank's Agents suggests that pay growth in the non-financial sector is likely to remain subdued in the period ahead.”

Looking ahead, the Monetary Policy Committee’s (MPC)  inflation report published last week is forecasting that inflation will “remain high” in the coming month, with inflation likely to fall back towards the 2% target in the second half of 2010, and may even fall below target in 2011. “Although inflation is temporarily above the target, the latest Inflation Report forecast suggests that the underlying pressures are to the downside,” King summarised.  http://www.proactiveinvestors.co.uk/companies/news/13376/bank-of-england-still-concerned-about-low-pay-growth-and-spare-capacity-in-uk-economy-13376.html