Missed inflation target chips away at Bank of England's credibility

The message from the Bank of England was crystal clear: having declined to take action to bring inflation back to its 2% target for the past four years, Threadneedle Street has no intention of changing course now. Policy will remain unchanged, or even become a little looser, even though the Bank estimates it will be 2015 before the annual increase in the cost of living is back on track.

In the past, such a forecast would have been enough to prompt a tightening of policy. The Bank's monetary policy committee would have raised interest rates to dampen inflationary pressure. That, though, was during what Sir Mervyn King dubs the Great Stability, the 15-year period between Britain's exit from the Exchange Rate Mechanism on Black Wednesday and the start of the financial crisis in 2007. The past five years have been the story of the Great Recession and its aftermath, with the Bank fearful that any attempt to hit the inflation target would clobber an already enfeebled economy.

"The prospect of a further prolonged period of above-target inflation must therefore be considered alongside the weakness of the real economy," King said. "Attempting to bring inflation back to target sooner would risk derailing the recovery and undershooting the target in the medium term."

Predictably enough, these comments at King's penultimate inflation report briefing were enough to send sterling lower on the foreign exchanges, but the soon to be departing governor will not mind that one little bit. King believes that the rebalancing of the economy requires the UK to export more, and a cheaper pound will help that.

The Bank says increases in tuition fees and domestic energy bills have made it considerably harder to hit the 2% target. The governor said that these costs accounted for only 16% of the basket of goods and services used to calculate the cost of living but were responsible for a percentage point of the current 2.7% inflation rate. In order to hit the official target, price increases for the other 84% of the inflation basket would have to be limited to just one percentage point.

That's a tall order, particularly when a lower pound is pushing up the cost of imports. As a result, the Bank is already adopting a "flexible" approach to the inflation target favoured by Mark Carney, the governor designate. That's "flexible" as in not really trying to hit it.

All of which raises a number of intriguing questions. If hitting the inflation target is too difficult to achieve, why not move to a target that is realistic? King opposes this idea, insisting that the Bank is serious about inflation and would respond to any sign of growing domestic inflationary pressure. In the meantime, Threadneedle Street is drawing on the reserves of credibility it built up in the good times.

A second question is whether the continued reliance on monetary policy to boost growth is tantamount to pushing on a piece of string? The governor would not quite go that far, but he did admit that the Bank was climbing an ever-steeper hill through its use of rock-bottom interest rates and quantitative easing to stimulate activity. As time passed, "larger and larger doses of stimulus" were required, he noted.

So, if that's the case, is there an argument for a rebalancing of policy with monetary policy shouldering less of the burden and fiscal policy – taxes and spending – having a bigger role? Having strongly supported George Osborne's austerity programme since 2010, King could hardly have been expected to say it was time for a discretionary cut in taxes or less draconian spending cuts and he insisted that monetary policy should be supported by (unspecified) supply-side reforms and by an export drive.

This is all well and good, but cannot disguise the fact that the current mix of policy has not worked. In each inflation report, growth is revised down and inflation is revised up. Growth is being stunted by a lack of consumer spending power, a lack of credit for small businesses and poor export prospects. If King is right in his analysis, Osborne is being over-optimistic in his expectation that the new governor can do much more with monetary policy. Instead, the chancellor may need to look at what he can do himself.