Mervyn King on behalf of the MPC committee sent an opened letter to the British finance minister George Osborne explaining why the annual inflation exceeded the 3% upper bound set by the government as today's news showed that CPI for April climbed to 3.7% which is more than one percent above the 2% target.
He mentioned that the rise was spurred by three factors which are the surge in oil prices, the restoration the VAT since January to 17.5% from 15%, and the ongoing depreciation to the royal pound since 2007. These factors outweighed the downside pressure on prices stemming from the substantial margin of spare capacity. However, he expects that these factors, if not increased, would impact inflation for a year at maximum as it would diminish with time, especially as the substantial margin of spare capacity brings back prices to the target.
Moreover, King said the policy action undertaken by the bank in May by keeping both interest rate and APF unchanged will give a boost to spending which in turn will hold inflation at high levels over the medium term, referring that the influence of spare capacity in the economy could be more significant than assumed.
Finally, he pledged to adopt suitable policies in the upcoming period to keep inflation near the 2% target over the medium term to boost growth in the economy that started to show improvement.
In response, Osborne replied with a letter showing his understanding to the factors mentioned by King and announced that prices will come back to target within a year matches the Treasury forecasts which state that inflation in the fourth quarter will reach 2.1% before dropping to 1.7% in 2011. In addition, Osborne confirmed that his government's main priority is reducing the budget deficit by holding an emergency budget on June 22as well asother measurees, as announced yesterday.