The minutes of the latest meeting earlier this month showed that all nine members of the Bank of England's monetary policy committee voted to keep interest rates at the all-time low of 0.5% and to continue with the quantitative easing programme of asset purchases up to £175 billion.

The MPC professes to be reasonably optimistic that the asset purchases are having the desired effect on money holdings, and thus eventually on growth, but it is still looking at ways to increase its effectiveness —for example, at the idea of reducing the interest rate the Bank pays on commercial bank reserves.

Moreover, Governor Mervyn King and two other members were outvoted at the August meeting on their desire to expand the purchase programme even further to £200 billion. So clearly there is some unease and a feeling that policy needs to made even looser to stabilise the economy.

And yet, in the September minutes lurk some disturbing comments on the inflation outlook which could limit the MPC's room for manoeuvre.

The Bank warned: “CPI inflation excluding the contributions of food and energy prices (i.e. core inflation) had remained stubbornly high over a number of months, despite the large degree of economic slack that the Committee believed had opened up in the economy.”

The MPC put forward three possible explanations for this:

* “The past depreciation of sterling was continuing to have a more persistent impact than previously thought”

* “The Committee might have misjudged the amount of economic slack in the economy”

* “The margin of spare capacity was in line with the Committee's assessment, but that it was having less of a depressing effect on inflation than the Committee had expected. That might have reflected the fact that inflation expectations were reasonably well anchored to the 2% CPI inflation target, and that they were having a greater stabilising influence on actual inflation than the Committee had anticipated.”

Whichever is true, the MPC members are clearly becoming less comfortable than hitherto about the inflation outlook, as well they might be. The low point for inflation in the Eurozone was an annualised rate of minus 0.7% in July whereas the best that the UK is likely to achieve is a low of about plus 1% in the forthcoming September data, compared with the August figure of plus 1.6%. If we try to forecast the path of UK inflation based on reasonable assumptions about the paths of the most volatile components — utility, petrol, and food prices — it is easy to obtain figures well above the 2% target throughout most of 2010.

Yet, after a short-lived blip in the first quarter to 2.1%, reflecting the move back of VAT to 17.5% in January, the Bank then forecasts that inflation will fall back well below 2% during the course of the year to reach 1.4% by the fourth quarter.

How can that be? The MPC must be assuming that the inflation rate of the non-volatile components, i.e. core inflation, will be falling steadily throughout the year.

So here is the problem. Normally, one would expect that in the aftermath of a deep recession such as the UK has just experienced, core inflation would fall steadily and dramatically as aggregate demand collapses and unemployment rises sharply (which it has).

Yet, as the MPC minutes highlight, the trend in core inflation has not fallen.

The recession started in the second quarter of 2008, at which time core inflation was 1.5%. Since then, it has averaged 1.7%, with the latest reading for August 2008 being 1.8%. The savage recession has not reduced core inflation at all!
This presents the MPC with a real dilemma. At recent Inflation Report press conferences, the Bank Governor has gone out of his way to stress the downside risks to growth and we think he is right to do so. It was only a year ago that the world economy was staring into the abyss, prompting massive co-ordinated policy easing by the major governments.

Now, largely because of that stimulus and a colossal destocking cycle, most economies should emerge from recession in the third quarter of this year. However, the fundamentals are still weak and likely to remain so as the world embarks on the process of deleveraging.

The burst of optimism as economies claw their way back to dry land has sparked an equity market rally and already a debate on when central banks should embark on their exit strategies — i.e. start reversing their easing by raising interest rates.

The Bank of England has said clearly that the only criterion to use to decide the timing of this move should be the inflation target of 2%. If inflation looks likely to rise above 2% at the two-year target horizon then the first rate increase will be made.

Viewed in this light, we can see why the MPC's comments on core inflation are so disturbing. We think it is almost certain that the MPC will steadily revise up its inflation forecasts in the next couple of Inflation Reports, not only to reflect a less aggressive view on core inflation but also its latest updated view that no more cuts in utility prices are now likely.

The MPC could thus be painting itself into a corner. At the present time, it is still exploring ways of easing policy further and, rightly, we think it does not want to make the first rate increase until late in 2010 when the path of the economic recovery should be more solid.

However, the deteriorating inflation fundamentals bring the risk that the MPC might be forced to make that first move earlier than it would really like.

Brian Hilliard is Chief Economist, UK at Société Générale Corporate & Investment Bank