Inflation to stay above target

The Bank of England will continue to miss its inflation target, its governor Sir Mervyn King warned this week. Inflation, he said, "may remain above the 2 per cent target for the next two years". As it was last below target in 2009, this would imply six years of overshooting.

But this prospect will not lead to a reversal of quantitative easing or a rise in interest rates soon, a typical tightening tool used to rein in inflation in previous eras. Sir Mervyn blamed the inflation overshoot on "administered and regulated prices" such as higher utility bills and tuition fees. These, he said, "contributed around one percentage point to inflation at the end of last year", and are expected to continue to add to inflation. He promised that, as long as cost pressures remain low - and wage inflation is only 1.4 per cent - he will "continue to look through the temporary, albeit protracted, period of above-target inflation in order to support the recovery". Unemployment, he said, is "much too high".

This reopens the question of how far the Bank is really targeting inflation at all, but is instead focusing upon real growth. Chris Williamson of Markit says: "The Bank's decisions on monetary policy will not be determined by the rate of inflation for the foreseeable future." James Knightley at ING Bank adds that "there does appear to be a slight easing bias". Futures markets are pricing in only a quarter-point rise in Bank rate before the spring of 2015.

The prospect of above-target inflation, in itself, isn't disastrous for gilts. While returns on cash stay low, and there's the possibility of more quantitative easing and continued low yields in the US, UK gilt yields are unlikely to rise much.

Another two years of negative real interest rates might tempt savers to spend more or to switch into riskier assets such as equities. This is, in part, precisely Sir Mervyn's intention: loose monetary policy works by encouraging people to spend and invest.

Such moves, however, are risky. Sir Mervyn warned that recovery will be "slow", which is not a great background for equities. Worse still, he pointed out that "there are limits to how much we can boost domestic demand through general monetary stimulus". This poses the nasty risk that if the economy is hit by another shock, there might be little ammunition left for the Bank to use to cushion us from it.

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