Bank of England governor has had an easy start, but he should remember Britain is a land of inflation and housing bubbles
Mark Carney has had the dream start as governor of the Bank of England. His predecessor, Mervyn King, had his work cut out in a crisis-ridden second five-year term, grappling with a financial meltdown, a deep slump and a stuttering recovery. Carney's six weeks in Threadneedle Street have seen unemployment come down, growth pick up and – as the latest official figures showed yesterday – price pressures abate. The new captain has been piped aboard the ship just as the storm has blown over.
The July fall in inflation was small but significant. There was speculation a couple of months ago that one of Carney's first tasks as governor would be to write to George Osborne explaining why inflation was more than a percentage point above the government's 2% target. That proved overly-pessimistic and after rising to 2.9% in June, inflation edged down to 2.8% in July.
Further falls can be expected over the months to come as the quite chunky monthly price rises in the late summer and autumn of 2012 are replaced by smaller increases this year. Last year, prices rose by 0.5% in August, 0.4% in September and 0.5% in October, and unless there is an unexpected spike in the cost of food and fuel similar increases look improbable in 2013.
Martin Beck, analyst at Capital Economics said the upshot is that inflation will be quite close to 2% by the end of the year, considerably lower than the Bank's own forecast, which shows it still hovering close to 3%.
This matters both for the Bank and the wider economy. Firstly, it will suggest that the long period of above-target inflation is drawing to an end. Since 2007, the only time the annual increase in the cost of living has been running below 2% was during the winter of 2008-09 when the economy was imploding. The rest of the time, it has been above target, twice peaking at more than 5%. There is only so long a central bank can fail to meet a legally constituted inflation target without losing credibility.
The second reason falling inflation matters is that it removes one of the obstacles to keeping interest rates low. Carney said last week that the Bank's monetary policy committee intended to keep the cost of borrowing at its record low of 0.5% but there were certain circumstances in which a re-think might be necessary. One of those circumstances would be a forecast that inflation in 18-24 months time would be higher than 2.5%. The Bank has never forecast inflation of higher than 2.5%, even when it was running at more than 5%, so the chances of it doing so when inflation is coming down seem remote to say the least.
Finally, falling inflation helps ease the squeeze on real incomes, increasing the chances that the recovery seen in recent months will persist. This effect should not be exaggerated since even after July's fall to 2.8%, prices are still rising faster than earnings, which are going up by 1% a year. Living standards will continue to be eroded during 2013 and early 2014, but by this time next year they could start to rise as inflation falls and a growing economy leads to higher pay settlements.
Further out, the risk is that inflationary pressure starts to increase again. The fall in sterling since the start of the financial crisis has made imports dearer. The Bank has kept interest rates ultra low for more than five years and created £375bn of electronic money through quantitative easing; the Treasury is handing out subsidies to home buyers: all the ingredients are there for a housing bubble that has spill over effects into the rest of the economy.
Carney and his colleagues would be well advised to keep a close eye on what is happening to real estate, since one of the lessons of the financial crisis is that the economy can come off the rails even when the official measure of the cost of living is well behaved. Looking at official data over coming months it may be tempting to see inflation as yesterday's problem but, Britain being Britain, it is likely to be tomorrow's problem as well.