Bank of England says inflation will increase further but signals it will keep policy loose

LONDON – The Bank of England predicted Wednesday that the U.K.’s inflation rate may hit 3 per cent by summer — but pledged to tolerate the increase in an attempt to help the economy recover.

Outgoing Bank of England Governor Mervyn King said inflation would be above the central bank’s mandated 2 per cent target for another two years, but that there is cause for optimism and that an economic recovery is in sight. He told reporters the bank would look past inflation figures to support growth and employment.

“This hasn’t been a normal recession, and it won’t be a normal recovery,” King said. “Our economy faces big challenges stemming from an abrupt and substantial reassessment of future economic prospects triggered by the financial crisis.”

Unlike the U.S. Federal Reserve, which aims to control inflation and also increase employment, the Bank of England’s exclusive mission has been to keep inflation close to 2 per cent. However, a “flexible” approach allows it to overlook temporary increases or drops in inflation to allow the economy to recover. Raising interest rates to lower inflation would hurt the recovery.

Bank of Canada governor Mark Carney will take over the top job at the Bank of England on July 1. Carney was hand-picked by U.K. chancellor George Osborne to take charge of the storied, 319-year-old institution, the first foreigner to ever do so.

King did caution that the recovery would not be smooth. Uncertainty about the solvency of banks has led to a reduction in credit, and expectations about future income have reduced demand at home — and the same factors abroad have hurt the demand for exports, the bank’s statement said.

“Although output has been broadly flat for the past two years, that masks a more encouraging underlying picture,” King told reporters at a news conference. “The bulk of the economy – primarily the services and manufacturing sectors together – actually grew at the steady, if unspectacular, rate of 1.2 per cent over 2012.”

As King spoke, the pound began to fall, trading 0.6 per cent lower at $1.5579 by midafternoon in London, on expectations that monetary policy would remain loose. Lower interest rates tend to weaken a currency as investors seek higher returns elsewhere.

Jason Conibear, the trading director at Cambridge Mercantile, said the pound’s rapid depreciation since the start of the year has fuelled inflation and further muddied the economic puzzle. Despite predictions from the Bank of England and the Confederation of British Industry that the economy would return to growth, he said doubts about the fragility of the recovery would dominate the bank’s monetary policies.

“Market confidence in the pound was already thin,” he said in a statement. “The governor’s admission that the inflation target is to be quietly ignored while the economy remains in intensive care has stretched it even further.”

The Bank of England, which was granted independence of the government in 1997, has had to adopt this more flexible approach to inflation in recent years because it has remained stubbornly above target since the financial crisis started in 2007 — even though the economy has fallen into recession twice.

According to the latest measures, inflation was 2.7 per cent in January.

Vicky Redwood, the chief UK economist at Capital Economics, said King’s willingness to look past the temporary albeit protracted period of high inflation means he’s adopting the flexible approach to inflation that incoming governor Mark Carney recently advocated.