Hamish McRae: The surge in inflation is the result of a cock-up, not a conspiracy

There is an obvious nightmare for British policy-makers. It is that the Bank of England will be forced by high inflation to increase interest rates before the economic recovery is secure. We all hear a lot about the fiscal dilemma facing the Treasury: that it has to tighten fiscal policy too swiftly. There has been much less debate about the monetary dilemma facing the Bank.

In the past few days, however, the nightmare has become a little more real. We have had inflation figures last week showing the Consumer Price Index up 3.7 per cent on the year and more alarmingly the Retail Price Index at 5.3 per cent. The RPI is the one still used for setting benefits and the return on index-link-gilts and is frequently used in union pay negotiations. Most alarming of all, the RPIX, that is the RPI excluding the impact of changes in mortgage interest rates, is up 5.4 per cent. That index was the one that used to be used by the Bank's monetary committee for setting interest rates and the central point was 2.5 per cent. On that measure, we are in really serious trouble.

The initial reaction to these figures was reasonably relaxed. For some of us, alarm bells were indeed ringing but the overriding market view was that these bad numbers would not of themselves trigger an early rise in interest rates or an early reversal of the Bank's policy of quantitative easing. But this week a report by the OECD called for interest rates to be increased from 0.5 per cent to 3.5 per cent by the end of 2011. The OECD puts it this way: "In the United Kingdom, the authorities face the challenge of preserving credibility, with headline inflation and some measures of inflation expectations exceeding the targeted rate in the context of extremely expansionary monetary and fiscal policies."

"Preserving credibility" is the key phrase. The Bank believes that inflation will fall sharply in the coming months. Its central projection is for CPI inflation to dip below the 2 per cent central point and, on the basis of market interest rate expectations, remain below it. That probably remains the majority view. However, there is a growing minority position that the Bank's credibility is at risk. For example, Simon Ward of Henderson Global Investors has made some projections for both CPI and RPI inflation, which paint a quite different picture. His CPI projection is within the Bank's range but, as you can see, towards the top of it. There is no Bank projection for the RPI but Simon Ward's one shows it stuck around 4.5 per cent.

So what rate of interest is appropriate if the RPI is 4.5 per cent? Well, in the past it would have been something close to 5 per cent. And what rate on medium-term gilts? You would be looking at 7 per cent. But actually things would be worse than that because if inflation were running at that level, the Bank's credibility would be shattered. The present system of setting interest rates by the monetary committee would have been perceived a failure and we would be forced to think of something else. So in a way those projections cannot happen; they cannot be allowed to happen.

So what will the path of inflation and interest rates turn out to be? There is a conspiracy theory here. It is that the country will try and inflate its way out of its debt problems, just as it has on several occasions since the Second World War. "QE" was a deliberate attempt to create inflation, under the guise of boosting demand, and to finance the government, which otherwise would have been unable to sell its debt. It would certainly have to pay a lot to finance the deficit. The Bank itself estimates that gilt yields would be one percentage point higher than they are now had it not been for QE.

Surely, the conspiracy theory view maintains, there must be a bias towards inflation when the Governor has had to write seven letters explaining why inflation is above target range and not a single one explaining why it is below?

I have some sympathy with this view but I think it is wrong. Yes, the aim of monetary policy was to boost economic output and one expected side effect of that would be to create some inflation. But in the emergency situation of a year ago this was a reasonable approach, given the balance of risks. I think it would be fair to say that the Bank has been taken by surprise by the inflation figures and inflation will jump again if, as expected, VAT is increased to 20 per cent. But I don't think it fair to say that the monetary committee is deliberately trying to push the country into a more inflationary environment. It would not make sense for it to do so, given how hard it has been for the country to rebuild monetary discipline over the past 30 years. Put crudely, I think the surge in inflation is the result of cock-up, not conspiracy.

For the moment, the markets accept this. They will continue to give the UK the benefit of the doubt at least until the emergency Budget on 22 June. If, as expected, this does indeed chart a credible path back to fiscal sanity, it will inevitably provide for a sustained tightening of fiscal policy. Under those circumstances it will be all the more important that monetary policy remains loose.

My guess is that there will have to be a path towards normality in monetary policy, just as there has to be in fiscal policy. There is a difference in that you would expect monetary policy to be more flexible and you certainly would not expect the Bank to set out a programme for increasing interest rates. But it would be sensible to set out a programme for rolling back QE – how the Bank and the Treasury plan the exit by gradually selling the £200 billion portfolio of government stock back to real investors. People buying government stock have a right to know not only how much more of the stuff will be issued to finance the deficit but also how this great wodge of additional debt will be unloaded. You could see the Government outlining a programme to sell the debt over a period of say three years, with so much per month. There needs to be some discretion over timing, for you don't want to tie the Bank's hands too tightly. But a statement of intent would be most helpful. Remember, the UK is not alone in this policy. Both the Federal Reserve and the European Central Bank have broadly similar schemes and the ECB has taken on the additional burden of buying the debt of the weaker eurozone countries too.

Once this was clear the Bank would then have much more leeway in setting rates. This would, so-to-speak, buy it a bit of credibility. I still think we will get the first increase in rates before the autumn is out but that need be no disaster. Indeed, a rise in rates might increase confidence for it would suggest that the inflation threat was being taken seriously, and not before time.

h.mcrae@independent.co.uk