Page last updated at 17:06 GMT, Tuesday, 16 February 2010

Why inflation letter held no surprises for chancellor

By Anthony Reuben
Business reporter, BBC News

The governor of the Bank of England, Mervyn King, has had to write to the Chancellor of the Exchequer, Alistair Darling, to explain why inflation is so high.

Mervyn King (left) and Alistair Darling

He has to do this every time inflation, measured by the Consumer Prices Index (CPI) rises more than one percentage point above the government's target of 2%.

In January, CPI hit 3.5%, so Mr King had to explain why.

Mr King's letter identifies three main reasons for inflation being high.

The first and biggest reason is the rise in VAT from 15% back to 17.5% at the start of the year, following a little over a year at the lower level, as part of the government's attempts to stimulate the economy.

That obviously meant that most prices went up, except for things on which VAT is not charged, such as food and children's clothing.

But it seems odd for Mr King to be writing to Mr Darling to explain that prices have gone up because the Chancellor had decided to put them up.

A Treasury spokesman told the BBC: "Controlling inflation is the responsibility of the independent Bank of England. The UK monetary policy framework has not been changed."

The second reason Mr King gives is petrol price inflation. Petrol and diesel prices were higher in January than they had been in January 2009, as the graph below shows.

Graph showing petrol and diesel prices

As the governor notes, crude oil rose 70% between January 2009 and January 2010. The rise in VAT, which is charged on petrol and diesel, had an effect too.

Also, in January 2009 fuel duty was 52.35p a litre, compared with 56.19p a litre in January 2010.

So once again, the chancellor may be well-placed to explain the inflation rate than the governor.

The third reason the Bank governor gives in his letter is that the pound has been weak following a hefty depreciation in 2007 and 2008, which has meant that imported goods have been more expensive.

As Mervyn King says, "although the exchange rate has been broadly stable over the past year", the effects are still being felt.

In its own commentary on the inflation figures, the Office for National Statistics (ONS), which calculates them, mentions the first two factors but not the weakness of sterling.

The ONS says that the reason it did not mention the currency was that it had not been able to quantify its effect.

Another effect that is difficult to quantify at the moment is how much the Bank of England's quantitative easing policy has been boosting inflation.

Theoretically, the policy of creating £200bn to pump into the economy should be inflationary, but there has been little mention of that from either the central bank or the government.

The chancellor and the governor agree that high inflation will be temporary and that the real risk is that prices will fall too far in the coming years.

Nonetheless, as the main factors in high inflation were down to government policy, there can have been little in Mr King's letter that surprised Mr Darling.

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