Who will carry the can for inflation?

Prices are rising globally so Gordon Brown can do little to control the UK economy

As always, it's the economy, stupid. Strip down the speculation about Gordon Brown to the bare essentials and it comes to this: for the prime minister to have even a hope of recovering from his current unpopularity, he needs to get back the feel-good factor. Even that may not be enough to save his political skin, but without an economic recovery that seeps swiftly into consumer confidence the outlook will be truly bleak.

The key word here is swiftly. Turning the economy round takes time, and time is a luxury Brown and his government do not have. The IMF's health check on the UK published on Friday predicts that the economy will continue to lose momentum for the rest of this year, with growth running at an annualised 1% by the end of 2008. The Bank of England sees things pretty much the same way. These realistic, perhaps even optimistic predictions signal at least six months of negative headlines about falling house prices, weaker consumer spending, rising prices and - in all probability - higher unemployment. In those circumstances, there is a strong risk that voters become even more convinced that Brown and his ministers are rabbits in the headlights.

One problem facing the government is that it can do little about the two factors that have pushed up inflation in recent months - food and energy prices - since they are subordinate to global markets. It is possible - highly possible, in fact, - that the oil bubble will burst over the coming months and that will bring down the price of petrol. But Brown will find it hard to claim credit for what will be an international development, even if, and it's a big if, he can raise a head of steam at the G8 to put meaningful pressure on Opec.

Better Fed

An even greater handicap is that economies generate lots of momentum, in upswings and downswings: it is mightily hard to slow down an economy that is booming and it is equally hard to re-invigorate an economy that is faltering. This economy is still in the slow-down phase, perhaps six or nine months behind the United States.

To have any hope, Brown needs swift and deep cuts in interest rates of the sort the Federal Reserve has announced. This would not be a sufficient condition to ensure political recovery - particularly if it led to a plunging pound and even higher inflation - but it is a necessary one. The prime minister would not be human if he did not sometimes wistfully compare the monetary policy activism of Ben Bernanke with Mervyn King's caution.

The mood music coming out of Threadneedle Street suggests that bank rate will stay on hold for months - the opposite of what Brown needs. King expects to write a number of letters to the chancellor explaining why inflation is more than a percentage point above its 2% target, and the feeling in the City is that further cuts in bank rate are off the agenda until King puts away his fountain pen.

If this proves to be the case, it will expose a weakness with the system, since instead of being proactive and pre-emptive the Bank's monetary policy committee will be reactive and backward-looking. Any gains from transparency are outweighed by making the MPC think its hands are tied.

A second barrier to lower rates is that the MPC is trying to hit the wrong inflation target. There are plenty of reasons to be wary of using the consumer prices index as a measure of inflation, the exclusion of house prices to name but one. Had house prices been included in the cost of living index a few years ago, rates would have gone up sooner and avoided the excesses of the property boom; if they were included now, falling house prices would mean interest rates would fall more speedily.

King has stated publicly that he would like to find a way of measuring house prices; in the absence of that, the next best solution would be for the MPC to stop targeting headline CPI and target a core measure instead.

This would require the Bank itself to show some flexibility, since there is no possibility that the government, in its weakened state, could announce that it was formally changing the inflation target. The credibility of fiscal policy has already been damaged by the £2.7bn tax cut announced nine days before the Crewe and Nantwich byelection; moving the goalposts with the inflation target would destroy the credibility of monetary policy as well.

Moving targets

Yet a decision to set the bank rate using a core measure of inflation - excluding food and energy - would make eminent sense. The Bank has no control over food and energy, yet they account for 1.7 percentage points of the increase in inflation over the past year. The rest of the economy has accounted for 1.3%.

The view of the majority on the MPC is that cutting interest rates would signal that it cared more about sustaining growth than it did about hitting the inflation target. It did, however, adopt a different approach when, at the end of 1999, oil prices under $10 a barrel pushed inflation well below its target. At that time, the Bank took the view - rightly - that the deflationary impact was temporary and that it was more important to look at what would happen over the next couple of years.

Conduct of monetary policy is supposed to be symmetrical, which means that the Bank should be just as willing to look through the short term now as it was at the end of the 1990s. Otherwise, it might give the impression of suffering from one of the traditional failings of independent central banks: caring more when inflation is above target than when it is below target.

There is a risk that higher food and fuel prices will lead to firms putting up prices and workers winning higher pay claims, but the risks of an inflationary spiral are slim. If pay bargainers were unable to bid up the price of labour in a boom, are they really going to be able to get compensation for dearer petrol when the labour market is weakening? And though firms may want to raise prices, it is a highly competitive world: when consumers stop spending - as they will - retailers will be forced to absorb higher costs in their profit margins.

Judging by the minutes of the May MPC meeting, there is little prospect of the Bank using the low level of core inflation as a reason to cut rates. Having set up an independent central bank and given it a specific set of rules to operate by, the government must live with the consequences. These could well be severe. First, the economy will be driven into a needlessly deep recession. Second, the Bank will undermine its own credibility and call into question the whole monetary framework. Finally, the man who unveiled that framework 11 years ago will be history.


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