If the Bank of England ceases to be viewed as a credible inflation fighter, it will no longer be able to support the economy through its monetary policy, Bank Deputy Governor Paul Tucker said on Tuesday.
The Bank restarted its asset buying programme last month to support growth, despite persistently above-target inflation, on the basis that price growth is forecast to fall sharply at the start of next year as one-off shocks fade.
In a speech to London financiers, Tucker said the Bank's judgement that it had been appropriate to allow inflation to exceed 2 percent for longer than usual would soon be put in the spotlight.
An absolute precondition for maintaining our support to demand is the credibility of monetary policy. Over the next few quarters, the Committee's most important judgement call will be put to the test. We will all discover whether inflation declines rapidly from 5 percent towards 3 percent, he said.
Most economists polled by Reuters expect the Bank to approve further quantitative easing in February, when it will have completed the 75 billion pounds of gilt purchases it decided on in October. However, if inflation proves sticky that may be the last stimulus move, even if growth remains weak.
Mr Tucker's speech highlights what is, in our view, the main risk associated with the UK's current monetary policy stance, said Barclays Capital economist Chris Crowe.
The MPC has staked its credibility on its forecast that the degree of spare capacity in the economy would rapidly bring inflation back to target. If inflation proves stickier than the MPC expects, an extension of QE beyond the additional 75 billion pounds that we expect in February 2012 seems unlikely.
Tucker also said it was important not to get too downbeat about the economy's medium-term prospects, despite the fact that the euro zone debt crisis had drained confidence from financial markets as well as the real economy in Britain.
Gloom should not be overdone. The record is that flexible economies with sound macroeconomic regimes recover from almost any crisis. The UK will recover, he said.
That said, a recovery would not be immediate. Even if, as we all hope, a credible solution to the euro area's problems can be put in place in the coming weeks, the traumas of the past few months will take a while to overcome.
Last week the Bank slashed its growth forecasts and Governor Mervyn King said the economy could stagnate until the middle of next year.
Tucker is viewed as one of the more hawkish members of the nine-man Monetary Policy Committee, and he revealed that he would have voted to raise rates in February if it had not been for shock data just before the meeting showing the economy contracted at the tail-end of 2010.
Up to that point, there had been signs that markets were starting to doubt the Bank's inflation credibility, he said.
Like Bank chief economist Spencer Dale -- who did vote for higher interest rates in February and for several months after -- Tucker said weak productivity growth was a major puzzle in Britain's economy, and one which did not appear to be explained by firms hanging on to unneeded workers.
He also said Britain's rebalancing towards more export-oriented growth and away from domestic consumption was likely to be slow, painful, and hampered by banks' reluctance to lend.
(Reporting by David Milliken; Editing by John Stonestreet)