The Bank of England has had a torrid time of late, with inflation persistently overshooting its forecasts and a series of letters to the Treasury to explain why this has been the case. Independent analysis shows that nominal spending in the UK is rising and inflation has hit four percent. Cries can be heard from the City – particularly from investors concerned with the value of their bond portfolios – that the bank is losing its inflation-fighting credibility and prices are slipping out of control.

Such fears are overdone. The bank has correctly pointed out that a string of one-off factors – VAT rises and commodity price shocks – have pushed inflation up. Strip these out and we see that core inflation is closer to two percent. What is more, with so much spare capacity in the economy (unemployment remains at 7.9 percent); there is little reason to expect core inflation to rise.

None of the side-effects of core inflationary pressure are yet in evidence. When wages do not keep pace with inflation, firms get a greater share of earnings and they can employ more staff, causing unemployment to fall. But there is little sign of such forces exerting a strong pressure to close the employment gap. Rising employment and increased core inflationary pressure would also, if they were taking place, lead to higher output. But UK GDP actually contracted by 0.5 percent in the fourth quarter of 2010. This was partly due to snow, and may be partly made up in the first quarter of 2011 as economic activity is displaced across time, but the UK seems to have fared worse than the US, Germany or France – suggesting that the tendency in Britain is still for the output gap to widen.

Admittedly, the available spare capacity in the UK economy may be less than is commonly assumed as frictions and uncertainty prevent firms from hiring new workers. This would cause the effects of nominal spending increases to be tilted towards inflation and away from output growth. But, with official unemployment sitting at three percent above trend and actual unemployment probably higher than official statistics detect, it is hard to believe that spare capacity is zero or anything like it.

Even if elevated core inflation were more likely than my analysis suggests, a brief period of above-trend inflation could actually be good for the economy, and for laid-off workers, if it eroded real wages, making it possible to get people back into work. It could also permit real house prices to fall without precipitating another recession and could soften the paralysing effects of debt. This latter would he hard on creditors, but it would not cause financial-sector distress (unless it was followed by a sharp interest-rate shock) as the value of bank liabilities would be eroded alongside their assets.

It may be that the commodity price shocks of the past twelve months will prove to be anything but temporary and will be repeated many times as we experience a combination of increased global demand, depletion of the cheapest resources and supply disruptions arising from floods, storms and other effects of global warming. In this case, a permanently tighter monetary stance would be needed to prevent persistently high inflation, with its corrosive effects on real investment and growth. But, while environmental stress will undoubtedly affect the economy in the years and decades ahead, it is far from clear that it will immediately cause inflation to rise and, when it does, central banks will have plenty of time to act, without premature tightening now.

Over the next few years, harsh and prolonged fiscal tightening will tend to keep a lid on core inflation. There is thus no case for a sharp monetary tightening. Interest rates should be increased slightly, but only because monetary policy is currently on its loosest setting in the bank’s 300-year history. Such monetary ease was necessary in late 2008 and early 2009 when the financial system was on the verge of collapse, but it is now excessive and should be unwound. However, even as it tightens marginally, the bank should stand ready to reverse course if employment and output decline again.