Monday, the inflation report was released with the CPI (Consumer Price Index) attaining 3,1 %. This means that realized inflation has gone well above the target of the BoE of 2 %. Whenever the target is surpassed by more than 1 % the Governor of the BoE has to write a letter to the Chancellor of the Exchequer and explain the reasons of deviations. This is not just a formality but the recognition of a failure by the BoE to fulfill its mandate. The letter needs to address the causes and remedies (see below copy of the letter sent to the Chancellor by Mr. King, the Governor and the Chancellor’s response). The 3,1 % level is the highest level since 1997 and it is obviously worrying for the BoE. Even more worrying has been the difference between the so called official inflations (or CPI) and the “headline inflation” that has attained 4,8 %. Many economist consider that CPI does not truly reflect the true cost of living in Britain(this number excludes mortgages and council taxes).

Also this week the BoE released the minutes of its previous meeting where the different positions (hawks and doves)were divided between a immediate hike in the May month (hawks) and those supportive of a wait-and-see policy (doves). The CPI report has provided ammunition to the hawkish stance. Markets have fully priced in a 25 basis point increase in May and the May meeting might see the hawkish band calling for a further increase.

All these events together with a US economy with few signs of strength has pushed the pound higher relative to the dollar well above the 2 dollars per pound threshold. Pressure from the carry trades has exarcebated this effect with the pound been highly demanded relative to low yielding currencies such as the yen or the swiss franc. The UK has gone through an expansionary phase in the business cycle and has been unable to control the inflation imbalance. The example of the UK will be watched closely by the European Central Banks.

The Bank of England Governor's letter

http://www.bankofengland.co.uk/monetarypolicy/pdf/cpiletter070417.pdf

The Chancellor's response

http://image.guardian.co.uk/sys-files/Business/pdf/2007/04/17/chxresponse170407.pdf