February 14, 2008 | posted by Michael Baxter in UK economy |

If you are a regular reader of this newsletter you know the dilemma. But, yesterday, the Bank of England spelt it out in full.

You may recall, earlier this year the Daily Express called for urgent rate cuts. It has been a common theme – why can’t the British central bank take a leaf out of the Fed’s book, ask some, and slash rates – get the economy rolling along? The solution to the current economic difficulties does, after all, seem obvious. And so obvious is this solution that many have predicted sharp falls in the official cost of borrowing this year – some think rates will drop to just 4 per cent by the year’s end – from the current level of 5.25 per cent.

Well, yesterday, the Bank of England’s good doctor, Mervyn King explained why this may not be so simple.

Yesterday, the Bank’s latest quarterly inflation report was published, and here is the bit that matters.

Markets seem to be predicting a fall in interest rates to 4.5 per cent by the beginning of next year – and yet yesterday’s report showed that if that happens, it expects inflation to average 2.3 per cent over the next two years – that’s above its official target of 2 per cent.

Well, that’s alright, you may say – inflation will only be a fraction over target – go for it. Well that is the wrong thing to do; if you deliberately target a rate above the level you are supposed to, you stand the risk of making things far worse.

After all, the Bank of England doesn’t know for sure what inflation will be, it deals in guesses. It admits this and even presents its projections in the form of fan charts – showing the probability it is wrong.

Besides, if it were to deliberately target an inflation rate above its official target – it would send out the wrong message – that it is relaxed about inflation.

The reports also raises the spectre that in the short-term, inflation could rise more than a full percentage point above target – eliciting another letter from its governor to the chancellor – a danger we warned of last month.

But there is good news. Based on the assumption rates stay where they are, the Bank of England thinks inflation will fall below target – just. So, in fact, the report seems to imply at least one more quarter of a per cent drop, maybe two.

But, sometimes you have to stand back, take a helicopter view, and that’s what Mervyn did yesterday.

Looking at house prices, he said, “There’s no reason to expect house prices to be markedly above where they are now.”

But, looking at all this doom and gloom doing the rounds, he said, “Don’t be taken in by too many of the analysts, who are perhaps coloured somewhat by the environment within which they have to work in the financial sector. Getting outside is a pretty good antidote to that.”

And in those comments he seemed to reflect a growing feeling that the banks have become so pre-occupied with their problems that they have just assumed we are suffering just as much – it is possible the banks are just plain wrong.