By Jens Erik Gould From The Financialist

Most central bankers would consider it a faux pas to deliberately attempt to exceed their own inflation targets. Yet central bankers in Britain are behaving as if they’re aiming for a higher rate in the medium term than their 2 percent inflation target. While unemployment has fallen much faster than expected, the bank appears nowhere close to raising interest rates. Which puts them at risk of stoking more inflation than is their stated mandate.

Given that Britain just had a brush with deflation, a discussion about exceeding an inflation target might sound absurd. Consumer prices fell 0.1 percent in April, the first time since 1960 that the year-over-year rate has been negative. Far from thinking about above-target inflation, some investors are worried that more subdued headline and core readings in the coming months could lead to prolonged deflation. Indeed, the recent appreciation of the pound has made goods purchased abroad relatively cheaper for British buyers, decreasing the likelihood of importing inflation. Still, Credit Suisse analysts Neville Hill and Sonali Punhani say investors shouldn’t expect an extended period of deflation, or even a prolonged period of low inflation. “They would never confess to this in public,” says Neville Hill, “but they’re heightening the risk that they overshoot.”

The recent decline in inflation owes more to the fall in prices for imported goods such as oil than a plunge in domestic prices. Once the effects of lower energy prices and a stronger currency have subsided, inflation should accelerate and become more volatile, Hill and Punhani write in a May 21 report entitled “Intended Consequences.” In addition, the low unemployment rate means slack in the labor market has shrunk considerably. Wages are already rising, and that will fuel more inflation over time. “The unemployment rate is low and continuing to fall, suggesting that domestic inflation will be higher in two to three years,” Hill says.

Recent action by the central bank—or lack thereof—is perhaps the most important indicator that inflation could pick up substantially in the medium term. The unemployment rate fell to 5.5 percent in the first quarter, the lowest level since mid-2008, and average pay for employees rose 2.2 percent during that period compared with the previous year. Still, the bank hasn’t raised interest rates. That’s presumably because in an environment of high household and government debt, policymakers would much prefer a period of faster inflation and robust growth to one of stable consumer prices accompanied by anemic growth that might be prompted by premature policy tightening. The bank’s inaction also reflects a post-crisis world in which most policymakers are more concerned with avoiding recession than about stoking inflation, says Hill.

Britain’s current central banking stance is unique among developed economies. In the U.S., the labor market also continues to improve, but the Federal Reserve has signaled its intent to begin raising rates this year. And in the Eurozone, the central bank only recently began a quantitative easing program – a rate hike isn’t even a consideration. As far as the currency markets are concerned, says Hill, the pound should remain weak against the dollar if U.K. policy stays dovish. It will be more challenging for the pound to depreciate considerably against the euro since the European Central Bank is engaged in monetary stimulus.

Although the absence of any policy response in Britain surprised economists, Credit Suisse doesn’t expect a rate increase until next February. And another nine months of improving growth amid an unchanged benchmark rate should fuel inflation. “Normally, an economy growing faster than its potential with downward pressure on unemployment would be consistent with moving policy in a tighter direction,” Hill says. “But they’ve systematically failed to tighten and seem likely to continue to do so.”

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