Doubt cast on Bank’s inflation credentials

Doubt cast on Bank’s inflation credentials

By Chris Giles in London and Ralph Atkins in Frankfurt

Published: May 19 2008 21:42 | Last updated: May 19 2008 21:42

Investors are more sceptical of the Bank of England’s ability to tackle inflation than at any time since it gained independence.

In recent months, a widening gap between the yields on index-linked government bonds and conventional gilts indicates bond-market investors are willing to pay much higher prices for inflation protection. This suggests doubts about the credibility of the monetary framework as Britain enters its most inflationary period for more than a decade.

While he was the chancellor’s chief economic adviser, Ed Balls, now children’s secretary, described inflation expectations in bond markets as the “most important” test of credibility and confidence in monetary policy.

Paul Dales of Capital Economics said the gap could be the “first sign that the markets are starting to lose faith in the ability of the UK’s policymakers to deliver a low and stable inflation environment”.

Alongside rising surveys of household inflation expectations and corporate pricing intentions, economists said there was a greater risk of higher inflation returning to normal British life.

Malcolm Barr of JPMorgan said: “In every measure you look at, inflation expectations have already moved out of the range they have occupied in the last eight or nine years.”

Sensing that a loss of confidence in the UK from abroad is under way after sterling’s continued decline, Danny Gabay of Fathom Consulting said: “The ... markets believe the ‘macro policy miracle’ [since 1997] is more style than substance”.

On a 20-year time horizon, the government bond market now expects retail price inflation to average 3.76 per cent, according to Bank of England figures, compared with 3.47 per cent on the last trading day before Gordon Brown announced Bank independence. By comparison, the 20-year expectations two years ago were just 2.85 per cent.

The warning by Mervyn King, the Bank’s governor, that the “nice” decade (of non-inflationary constant expansion) was over prompted other economists to offer their own acronyms. Few yet expect a recession, but Michael Saunders of Citigroup said times will be “vile” – “volatile inflation, less expansionary”.

Jean-Claude Trichet, president of the European Central Bank, has urged policymakers to fight higher inflation. Soaring oil and food prices had created “demanding times, challenging times”, he told the BBC. The challenge was to ensure the pressures did not create lasting “second-round effects” by feeding through into wage deals.

Mistakes at the time of the first “oil shock” in the 1970s had “enshrined the high level of inflation for a long period” and led to mass unemployment. Mr Trichet sounded the alarm on inflation even as he acknowledged that financial markets were still witnessing an “ongoing, very significant market correction”.