Inflation alert leads to early debut of The ‘Oz’ and Mervyn show

So Mervyn King has a new penpal.

Prices are rising above target, and above forecast, yet again. And yet again the Bank of England says it is a temporary phenomenon that its interest-rate setting committee will “look through”.

Inflation on the main target measure reached a 17 month high of 3.7 per cent last month, that’s nearly double the 2 per cent target, and well above the 3 per cent bound, above which explanatory letters need to be penned.

In fact CPI has been at 3 per cent or higher for all of 2010, and that looks likely to remain the case at least until autumn. Oh, yes, the Retail Price Index is as a 19 year high of 5.3 per cent too. This creates a migraine for those parts of the Treasury planning public sector pay freezes (=real terms pay cut of 5.3 per cent), let alone pay cuts.

Worried savers can be forgiven for starting to worry about whether there is a gentle backdoor policy of tolerating slightly higher inflation in order to gnaw into Britain’s massive stock of public and private debt. And it isn’t just domestic savers.

I spoke with one of the world’s main bond traders. He feels that traders in that market are beginning to cotton on to a subconscious Bank of England policy of tolerating slightly higher-than-target inflation.

It isn’t that absurd a suggestion, the International Monetary Fund chief economist has floated the idea that inflation targets at 4 per cent could make more sense than 2 per cent. The BoE’s chief economist tellingly responded to the IMF with a robust speech against this notion in March.

In their exchange of letters today Chancellor Osborne reaffirms his “absolute commitment” to setting the Bank of England an inflation target of 2 per cent. Both the chancellor and the governor agree that the 4-month-and-counting elevation of inflation are temporary, down to the rise in VAT, excise duties, petrol prices and the fall in sterling.

The question is: at what point does temporary become more enduring? If VAT goes up again on 22 June, that will provide another boost to CPI inflation.

So when does the Bank start to raise interest rates, or quantitatively tighten (ie reverse QE)? Taken at their word, the bank and the Treasury believe the MPC can leave interest rates low for a long time, in spite of this bout of high inflation.

There is no fear of inflationary wage spirals, in the current jobs market, for example. Neither will many of the current sources of price pressures – oil prices, tax decisions – be reined in by a rate rise.

But then that means that the 2 per cent target is beginning to lose some of its lustre, some of its role as an anchor for prices. This slippery slope is seen as a more stable roadmap than the perilous road of simultaneous sharp rate rises and spending cuts.

The new chancellor’s letter contains the crucial clue – almost half of it on the new fiscal policy and coming cuts. Osborne’s hope is that the Treasury and Bank of England dance a tango of tight fiscal policy (spending cuts) and loose monetary policy (low interest rates). High and enduring inflation could wreck this dance.