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Last Updated: Wednesday, 19 October 2005, 23:13 GMT 00:13 UK
Bank of England faces policy headache

By Evan Davis
BBC Economics editor

Bank of England Govenor Mervyn King
The growth or inflation question may be proving a bit of a headache
What should the Bank of England be worried about?

Inflation? Or growth?

As it happens, this is really the issue that divides the world of economics at the moment. The big split in economic policymaking comes down to that.

So what are the arguments?

If you are one of those people who likes to look at the latest data on these things, you could be worried about both inflation and growth.

The target inflation measure, the CPI, is at 2.5%, a half-point above the target of 2%.

Yet growth is below average at the moment. In the third quarter it will probably come in at 0.3% when the figure is published on Friday. That's the quarterly equivalent of an annual rate of 1.2%, a bit dismal by our recent standards.

Katrina's blip

Which is why the question is being asked, should the Bank be worried by inflation or growth?

Now, formally, the answer to this question is easy. The Bank should worry about inflation. That is what it's paid to do.

The chancellor's first command to the newly independent Bank in 1997 was to deliver the inflation target. No-one is quibbling with that goal.

US petrol station with cars driving past
Oil prices have been motoring

But things are more complicated than that.

The latest inflation statistics reflect Hurricane Katrina's impact on petrol prices. Indeed, the higher inflation rate is mostly reflecting the oil price effect: take out energy, and the CPI would only have grown 1.7%, which is below the target rate.

And on one view, if it's oil price inflation that's the problem, we should ignore it. Oil price rises are not our fault - they tell us more about what is going on in China than in Chingford, and we shouldn't punish ourselves for them.

The Bank of England should worry more about other things - like the slowing economy, for example.

That suggests the Bank might want to cut interest rates, despite inflation being above target.

In effect, this is the view being propagated by many in the city who have been keenly expecting a cut in rates, possibly as early as next month.

Ups and downs

Now, that is not the view that seems to be most prevalent at the Bank of England. In a series of speeches recently - three in the last 10 days - members of the MPC have shifted the argument round.

The Bank seems to downplay the view that we should be worried about growth.

Instead of assuming that the odd quarter of growth below trend is a problem we need to solve, we should think of it as the natural order of events.

UK Chancellor Gordon Brown
UK growth has lost some muscle

The idea that the Bank's job is to fine-tune the economy so it hums along at a constant speed is absurd, MPC members have argued. They should be able to prevent wild gyrations, but not minor ups and downs.

Anyway, they might add, can you ignore oil price rises? If inflation stays at 2.5%, people will start building 2.5% into their expectations, thus making it very hard ever to get inflation back down to 2%.

Add to this the possibility that the growth figures may be underestimating the activity that's really going on (which they have done before).

Armed with these points, you would take the view that the Bank should not be particularly worried about growth and should strive to get inflation down to target (although it should not worry about the odd few months of inflation, caused by oil).

High expectations

Now that's a summary of the argument.

It's fair to say that within the Bank itself, there seems to be a diversity of emphasis on these points. Some worry more about the downside risks to growth, others more about potential upside risks to inflation.

Shoppers on London's Oxford Steet
Even die-hard shoppers take breaks

Fair enough, that's par for the course. MPC members have to make judgements about these things and they are not always going to agree.

But under the leadership of Mervyn King, the Bank would surely be right to stick to its guns on one key, non-negotiable point: it is not the Bank's job to iron out every wrinkle in the economy's performance.

Sometimes things need to slow down and there is nothing you should do about it.

After several years of strong consumer spending, consumers may decide to save more, causing a slowdown on the High Street and diminished growth. That's not a crisis or a failure - it is simply the natural counter to previous events.

Natural rhythm

Nothing could be worse than trying to stimulate the economy and cajole consumers back into the shops just as they get their finances back into order.

To put it in a somewhat patronising way, the public - and indeed the City commentators who constantly bleat that the Bank needs to cut rates - may need educating on this point.

After several years without any quarter of economic contraction, people have come to assume that growth just carries on uninterrupted. Expectations of what the Bank can achieve in this regard might be unrealistically high.

So if people want to argue that the Bank can afford to shrug off the odd period of oil-induced high inflation, surely the Bank is entitled to shrug off the odd period of slow growth.

To coin a phrase from Donald Rumsfeld, "Stuff happens." And it's not the job of the Bank to stop it.

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