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March 25, 2009

Dear Chancellor: Inflationary Facts
by Adrian Ash

A draft of this week's open letter - from Bank of England governor Mervyn King to UK chancellor Alistair Darling - which BullionVault found blowing down Threadneedle Street early Tuesday...

Dear Chancellor,

The Office for National Statistics (ONS) just published data showing that Consumer Price inflation in the United Kingdom rose to 3.2% in February from a year earlier.

Not only was that rate of inflation far ahead of analyst forecasts. Nor did it merely rip up a dozen newspaper front-pages, all trying to explain "deflation" to a nation paying nothing but rising prices since 1960.

And nor could the latest data fail to conceal the sharpest month-on-month jump of the last 19 years. (It was only just shy, in fact, of the worst monthly jump since the wipe-out inflation of spring 1980.)

No, the CPI inflation figure also rose more than one whole percentage point above our 2.0% target, as mandated by you. And that requires me to explain, in this open letter, why the cost of living is rising so quickly, rather than tumbling as everyone guessed.

"Oh bugger," as I believe Gordon of Khartoum said when the Mahdi army broke through.

The reason for this letter

Yes, so it's the fourth such letter of the last 10 months. But it's still only the fourth such letter since the Bank was given independence to set interest rates almost 12 years ago.

Only four letters after 142 inflation headlines since May 1997...? That's a far better goal difference than we should have expected. Not least because, since I became Governor, the UK money supply has swelled at an average 11.3% rate per annum.

Just last month, indeed, growth in the broad money supply hit almost 19% year-on-year - the fastest rate of expansion since the late 1970s. And "Few empirical regularities in economics are so well documented as the co-movement of money and inflation," as I used to enjoy pointing out.

Across the final three decades of the last century, in fact, the rate of growth in the money supply and the rate of price-inflation were virtually identical - not only here in the UK (on the Bank's own analysis), but across 116 countries in a detailed study of 1995.

Inflating the money supply only stopped inflating the cost of inflating in the first part of this decade - a period I previously said was all very N.I.C.E. (non-inflationary, constant expansion) but unlikely to last. Most especially with me running the Bank's policy team!

Even so, anyone at the Treasury hoping for a mea culpa today will have to accept this nostrum culpum instead I'm afraid.

Why has inflation moved away from the target?

In reviewing the current data, Chancellor...oh who are we kidding? You and I both know why deflation has failed to appear and why I'm having to write this letter once more.

• Cutting Bank Rate below its 300-year floor of 2.0%;
• Creating £10 billion out of thin air to buy up long-dated government bonds, with a further £140bn now at the printers;
• Announcing £148bn of new gilts to be issued this year to cover your own spending deficit.

Inflate money, devalue debt in short. And with such a very great deal of debt to devalue, that rare empirical regularity of economics would dictate a very great deal of monetary inflation.

It's happening much faster and far more dramatically than I had expected, however. Indeed, the inflation in prices is coming even as money-supply growth for private households has sunk to a four-decade low. That's quite the reverse of what I claimed would happen when this recession began, because I'd missed the plain fact that people spend - and don't save - when interest rates sink.

Debtors merely pay down their debts, and savers flee cash because they're much wiser than our policy models accept. Just recently, for instance, £2.3 billion was withdrawn - net, inside one month - from household bank accounts. We can't account for all of it, but very nearly one pound in every £100 went to Buy Gold at BullionVault.

Returning to Target in the Medium Term

Howsoever it's working, the "pass through" from our forced devaluation of Sterling - the devaluation we've so clearly wrought between us, now running to 28% on the foreign exchanges, and greater still against Gold Prices than both the IMF crisis of 1976 and the post-Gold Standard drop of the Great Depression - cannot be ignored for much longer.

Not with the Easter break looming, but air fares up 12% from April last year. Not with everyone planning their summer holidays, but finding package deals nearly 7% dearer. And most certainly not with the cost of food here at home more expensive by one-eighth in the last 12 months alone.

What to do? Frankly, I'm stumped - which is why I should most likely consider resigning today. The alternative, here in this letter, would be to lambast you and your administration for nurturing the very inflation that's now exploded, forcing you to take such desperate remedies as issuing public debt worth 11% of GDP over the next year, while forcing us here at the Bank to start monetizing that debt quantitative easing.

A buyers' strike at forthcoming gilt auctions cannot be far off, however, and now that everyone involved in this mess fears the public roasting (if not physical violence) threatened against our senior commercial bank chiefs, I shall opt instead to snipe and snip at your policies during this week's Parliamentary Committee hearing.

Sincerely,

Governor &c.

P.S: Hoping that at somehow, at some point, a withdrawal of this extraordinary stimulus will be both achievable and politically tenable is, quite frankly, absurd. You know it, I know it, and clearly the know-it-all continentals at the European Central Bank have guessed it as well. We mustn't expect the G20 summit to achieve anything like a consensus for any policies we propose. I suggest the PR team get to work selling that failure immediately.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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