* BoE insists inflation overshoot due to temporary factors
* UK inflation above target for 28 of last 34 months
* Once lost, credibility hard to restore
By Christina Fincher
LONDON, Aug 19 (Reuters) - Investors for now are buying the Bank of England’s line that inflation will prove short-lived, but after years of overshoots the central bank risks a deeper loss of credibility with markets if it is proved wrong.
Short-lived inflation certainly hasn’t been. At 3.1 percent in July, inflation is higher in Britain than in any other Group of Seven economy and has been above the BoE’s 2 percent target more than 80 percent of the time over the past three years.
The central bank’s excuses for why one-off shocks keep knocking inflation off course might be starting to look feeble were it not for the fact that investors seem happy to believe them.
Long-term inflation expectations remain anchored, UK asset markets have not underperformed their peers and 10-year gilt yields hit a 17-month low near 3 percent this week, below the current rate of inflation.
One reason why inflation expectations have not become unhinged is the renewed focus on the fragility of the global recovery and the impact of fiscal austerity.
Over the past three months, sentiment surveys have weakened, investors’ risk appetite has evaporated and data has pointed to falling price pressures and a faltering recovery in the United States and Japan.
“For as long as markets are more worried about the pace of recovery and risk of global deflation, the Bank of England’s credibility won’t be a big issue,” said Ross Walker, UK economist at RBS. “The problem will come when that focus changes.”
RBS’s Walker argues that Britain’s high level of household debt means the BoE will not have to tighten policy much to snuff out inflation, particularly if the country’s 100-day-old coalition government follows through with ambitious deficit-cutting plans.
Others, however, worry the central bank risks letting the inflation genie out the bottle, and will have a hard job putting it back in again.
Once lost, credibility can be hard to recover and spiralling inflation is hard to reverse, as Britain found to its cost in the 1970s and 80s.
Those worried the central bank is turning a blind eye to inflation have an ally in rate-setter Andrew Sentance, who has broken ranks to call for a 25 basis point rate hike for the past three months.
Minutes to the BoE’s August meeting show Sentance has so far failed to convince any of his colleagues to join him. But with UK retail sales surprising on the upside and surveys pointing to stubborn price pressures, some believe the market’s confidence the BoE will not raise rates till the second half of 2011 may be misplaced.
“The market is vulnerable to a continuation of the trend of upside inflation surprises, so it’s strange that there is no risk priced in of an earlier move,” said Sam Hill, a fixed income strategist at RBC.
“If I were on the MPC and had accepted responsibility for hitting a 2 percent inflation target, I would be getting increasingly uncomfortable.”
Editing by Patrick Graham