MERVYN KING, Governor of the Bank of England, has made little secret of his distaste for the Government's new inflation target, but like it or not, he's lumbered with the task of meeting and explaining it. The awkward question of why interest rates are rising when inflation is so far below the new target therefore falls to him to answer.
And no, it's got nothing to do with the contention that monetary policy has become more concerned with soaraway house prices than inflation, Mr King insisted yesterday as he introduced the Bank of England's latest Inflation Report. Rather, the explanation lies in above trend GDP growth, which in time will lead to capacity shortages, thereby increasing the amount of inflation in the economy.
If interest rates had been left unchanged after last week's meeting of the Monetary Policy Committee, then there would be a high probability of inflation being above the new, 2 per cent target two years hence. By raising rates to 4 per cent, projected inflation is returned to target. The reason why inflation was broadly on target under the old measure, but is currently under it on the new one is that the old measure takes account of house price inflation, while the new one doesn't. Exactly the same inflationary pressures exist around the two targets, whatever measure you use. Get it? Oh, never mind.
Despite these presentational difficulties, Mr King's underlying message was the most upbeat it's been in years. Whatever the Government's difficulties over Iraq, top-up fees, foundation hospitals and so many other aspects of domestic and foreign policy, the outlook for the economy seems to get better and …