Bank's inflation fears 'overblown'

IF THE Bank of England is to be believed, the inflation bogeyman is back. Explaining its decision earlier this month to lift interest rates for the second time in as many months, the Bank's monetary policy committee said inflationary pressures were likely to build as the economy's spare capacity is eroded.

And in its latest quarterly Inflation Report, it warned that inflation is set to overshoot its 2% target in two years, implying the need for higher interest rates to get it back under control.

The gloomy prognosis comes as conventional wisdom is that inflation has more or less been consigned to the history books.

True, rocketing petrol prices will drive it higher over the next few months, but this is a temporary blip. With competition on the High Street fiercer than ever and sterling riding high on foreign exchanges, there is every reason to think that the Bank is being far too pessimistic.

We've been here before. Back in January 2000, the MPC considered raising interest rates by a hefty half-point because it was worried about the imminent inflation threat of shrinking spare capacity and rampant consumer spending.

Its fears proved unfounded as inflation rose above target (which was at that time 2.5% on the retail prices minus mortgage costs measure) in just two of the next 32 months. The word being bandied about was deflation, not inflation.

Four years on, inflation on the new Consumer Price Index measure is running at just 1.5% and has been below target for more than five years. Encouragingly for the outlook, goods inflation remains in negative territory while services inflation is falling.

For the MPC, the consumer is the main threat to inflation, but its concerns look misplaced. While retailers are seeing their wares fly off shelves, they are having to slash prices to entice shoppers into spending.

As Geoff Dicks at Royal Bank of Scotland puts it, consumers are not inflationary, rather the reverse. 'We are canny,' he says. 'More and more we seem to delay our Christmas spending until the New Year sales which, increasingly and as a direct result, seem to start earlier and earlier.

'And if the bargains aren't there to be had, we walk away, knowing that excess capacity on the High Street will eventually lead to one retailer or another breaking ranks. We find it hard to see the consumer as a source of inflation pressure.'

In the service sector, meanwhile, inflation has halved from 6% to 3% over the past 12 months. The fall has been led primarily by cheap foreign holidays and air fares. With service providers increasingly fighting for business over the internet, expect inflation in the sector to keep falling.

So why all the inflation pessimism from the MPC? The popular theory among economists is that it is being used as a smokescreen to justify higher interest rates. After all, the MPC's remit is to set policy to keep inflation at 2%. But what the committee is really worried about are the housing and borrowing booms.

John Butler at HSBC says: 'If you think, as we do, that the Bank is concerned about the rapid rise in household debt and the threat of a re-acceleration in the housing market, then the current or short-term outlook for inflation is irrelevant. That is not to say that the MPC is targeting the household sector, but rather that it is prepared to give it special attention.'

RBS's Dicks adds: 'We, along with probably the majority of City economists, believe that the MPC has a slightly different agenda. It has to link its call on rates to its inflation remit and work backwards from that. Only a central bank that is worried about the stability of the financial system would be raising interest rates today on a forecast that inflation might just be above 2% in two years' time.'

It is not just at home that inflation is back in the headlines. Across the Atlantic, the focus of the US Federal Reserve has shifted from reviving the economy to keeping price pressure at bay.

After the tamest inflation numbers in decades, punctuated by Fed chief Alan Greenspan's warning of disinflation last year, prices are creeping up.

The Fed's favoured measure of inflation - the extravagantly named Personal Consumption Expenditure Deflator, excluding volatile food and energy prices - has nearly doubled from 0.8% at the end of last year to 1.4% in April.

Financial markets have been spooked by worries that America's ultra-accommodative monetary policy has allowed inflation to gather momentum, meaning interest rates will have to rise further and faster than expected. The first move, by a quarter-point to 1.25%, is expected next week.

Greenspan last week assured markets that inflation pressures 'are not likely to be a serious concern'.

Investors on both sides of the Pond are hoping he is right.