Persistently high inflation may prevent incoming Bank of England Governor Mark Carney from attempting radical monetary policy to help the recovery reach “escape velocity”, an influential consultancy has warned.
The Ernst & Young ITEM Club said “the persistence of high inflation could undermine the Monetary Policy Committee’s credibility” and “tie [its] hands”. Contrary to the Bank’s forecast for inflation to fall back to 2pc by early 2015, ITEM has estimated that will settle at 2.6pc in 2014 and 2015.
“As well as becoming a risk to the MPC’s credibility, persistent levels of high inflation may tie their hands when it comes to creating a more flexible system,” Carl Astorri, ITEM’s senior economic adviser, said.
Mr Carney takes over from Sir Mervyn King as Governor on July 1 with high expectations that he will shake up policy at the Bank. His first task will be to establish how guidance using “intermediate thresholds” such as unemployment targets could work in the UK, and report back in August.
However, ITEM said guidance would be less effective in the face of high inflation than a fundamental change of the remit, which the Chancellor ruled out by reconfirming the target of 2pc under the consumer prices index (CPI) in the Budget. “In this environment, alternative monetary policy remits, such as setting ranges for intermediate or proximate statistics like core inflation and nominal GDP, would appear to be more attractive propositions,” ITEM said.
Official inflation figures this week are expected to show that CPI fell from 2.8pc to 2.7pc in April, but economists expect inflation to rise. ITEM expects CPI to average 2.9pc for the year as a whole. “High inflation will remain permanent fixture in UK economy,” it said.
High inflation has already been costly to the economy, ITEM calculated. It has knocked almost 3pc off UK growth over the past three years, during which time inflation averaged 3.5pc. Had inflation been at the 2pc target with policy unchanged, ITEM calculated the economy would be £10bn larger today and 650,000 fewer people would be out of work.
However, the Bank was right to let inflation overshoot, ITEM stressed. Had it tightened policy to hit the 2pc target, the UK “would have seen interest rates rise to 3.5pc in 2011, choking off the recovery even earlier and adding an additional 625,000 people to dole queues”, Mr Astorri said.
Petrol and food prices are expected to ease later this year but underlying inflationary pressures from rising import prices, reflecting higher wages in emerging markets, and UK workers’ demands for belated pay rises will “build”, ITEM said.
Hopes of tentative recovery were fuelled on Monday by a report showing that pressure on household finances eased to its weakest in three years this month. The index, compiled by Markit, indicated that while household finances continued to worsen in May, the pace of deterioration slowed “substantially” over the month.
Signs that the economy has turned the corner and is on a slow recovery track, as the Bank forecast last week, are expected to be reinforced by official confirmation on Thursday that GDP grew by 0.3pc in the three months to March. Economists expect the Office for National Statistics to leave its first estimate unchanged.
The International Monetary Fund is also expected to deliver its review of the UK. It may follow through with its threat to demand George Osborne slow the pace of austerity to restore growth and get the public finances under control. The Chancellor has said he will not budge.