Friendly Cameron and King get mix right for now

July 2, 2010

By Ian Campbell

—  The author is a Reuters Breakingviews columnist. The opinions expressed are their own —

Just in government and David Cameron’s relationships are in question. Eyebrows have been raised about the prime minister’s friendship with an Old Lady, sometimes known as the Bank of England. The affection appears reciprocated by Mervyn King, the Bank’s governor. But to think the Old Lady’s independence is compromised is probably to take things too far. The bank’s current low interest rate policy looks more than just a political favour.

The overly friendly talk has arisen because both sides have made comments that might be deemed injudicious. King appeared in May, before the election, to give his backing to Conservative fiscal tightening plans. Cameron, meanwhile, has often mentioned how he thinks tight fiscal policy should allow interest rates to stay lower for longer. The new government has also fixed up the Old Lady with greater supervisory powers.

Could this chumminess lead to the wrong monetary policy? King’s critics might think so. Inflation is 3.4 percent, well above the 2 percent target. Andrew Sentance, one of the monetary policy committee (MPC) members, voted for a rate increase in this month’s meeting. Adam Posen, another MPC member, acknowledged “a direct difference with the governor” on one thing. He sees not just one-off inflationary factors but also a slight “unanchoring” of inflation expectations. And yet Posen also sees the UK poised between two very different outcomes — either recovery or “the renewal of a severe recession”. Similarly, David Miles, a third member of the MPC, believes that now is not the right time to raise rates even though inflation is “uncomfortably” high.

The great uncertainty means no conspiracy theories are required to explain the MPC’s position. There can be little doubt King approves of the coalition government’s plans for fiscal tightening. The VAT increase may make inflation worse. Not for nothing, perhaps, was it deferred to January. But the overall initial impact on growth of fiscal tightening is likely to be negative. If government departments do indeed slash budgets by a quarter, unemployment may rise a lot. Private sector wages are already depressed. Big cuts should bleed inflation painfully away.

Fiscal tightening is essential. And low interest rates themselves look essential — to avert the nastier of Posen’s outcomes. The UK is getting the policy mix it needs.

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