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The Bank's governor, Mervyn King, pointed out that CPI inflation was 3 per cent in April, and added that rising energy and import prices will almost certainly push inflation up further, possibly significantly, in the coming months.

As those price increases feed through to household bills, they will lead to a squeeze on real take-home pay which will slow consumer spending and output growth, perhaps sharply.

Supply of credit lowered 

King said in his introduction to the Bank’s Inflation Report that the balancing act faced by the Monetary Policy Committee was even more challenging than it was in February.

He added that financial market conditions had stabilised since the introduction of the Special Liquidity Scheme, but remained fragile.

Banks continue to adjust their balance sheets by raising new capital and lowering the supply of credit to the rest of the economy.

King said that the impact of tighter credit conditions was most clear in property markets. Commercial property prices have fallen by 16 per cent since the summer and house prices are now falling too.

“In these circumstances, the household saving rate is likely to rise. This is part of a rebalancing of the UK economy, away from spending and importing, towards saving and exporting – a change that will be supported by the depreciation of sterling, which is now 12 per cent below where it was in August,” according to King.

Growth to slow sharply 

The Committee’s latest projection for GDP is based on the assumption that Bank Rate moves in line with market expectations, which, when the report was finalised, were for a modest further fall in interest rates over the next year.

The central projection is for growth to slow sharply in the short term, reflecting the squeeze on real incomes, before recovering as credit conditions begin to ease and the depreciation of sterling boosts exports and reduces imports.

King said that the Monetary Policy Committee judges that the possibility of more prolonged restrictions to the supply of credit means that medium-term growth forecast were modest.

In the central projection, higher prices for domestic energy, food and imports push inflation markedly above the target this year

If, as futures markets anticipate, energy prices stabilise, inflation should start to decline around the end of this year and settle around the 2 per cent target in the medium term.

Open letters to the Chancellor 

The governor said that there was considerable uncertainty over that profile because it rests on assumptions about the magnitude and timing of further rises in domestic gas and electricity prices which are extremely difficult to anticipate accurately.

“Nevertheless, it is likely that, with inflation above 3 per cent for several quarters, I will be required to write a number of open letters to the Chancellor over the next year,” he added.

The unexpected rises in energy prices will, over the coming months, push up the overall price level and will remain in the official measure of inflation for 12 months thereafter.

To try to bring CPI inflation back to the target within this period would result in an undesirable degree of volatility in output, so King explained that the MPC is aiming to bring inflation back to target over a somewhat longer horizon.

“That does not, however, mean it is ignoring the near-term rise in inflation. The extent of the deviation from target this year is likely to affect the behaviour of those setting prices and wages,” he said.

Nice decade is behind us 

He pointed out that for that reason, the Committee judges that a slowing of demand growth this year - reducing pressure on capacity - will be necessary to ensure that inflation settles around the target in the medium term.

“The Monetary Policy Committee is facing its most difficult challenge yet. For the time being, at least, the ‘nice’ decade is behind us. The credit cycle has turned. Commodity prices are rising. We are travelling along a bumpy road as the economy rebalances,” according to King.

He said that monetary policy cannot, and should not try to, prevent that adjustment, stressing that the Monetary Policy Committee must focus on bringing inflation back to the 2 per cent target in the medium term.

King concluded that inflation would return to the target and growth would eventually recover to a sustainable rate, but warned that we would need to be patient.

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Related links

• Bank of England
• Inflation Report