At some point this summer, Mervyn King, the Bank of England governor, faces an unenviable task. For the second time in his tenure, he will have to write an open letter to the chancellor explaining why inflation has risen more than one percentage point above the 2% target and describing what the Bank’s Monetary Policy Committee plans to do about it.

Why have the institutional arrangements designed to anchor UK inflation failed for a second time?

In an accounting sense, the increase in Consumer Prices Index inflation since mid 2007 can be largely explained by rising global prices of food and energy. The deeper question, however, is why these higher prices have not been offset by slower rises or falls in prices for other products and services, as would be expected if monetary policy had been correctly calibrated to meet the inflation target.

Regrettably for its reputation, it is clear the MPC allowed excessively loose monetary conditions to develop between 2005 and 2007. Bank rate was cut inappropriately in 2005 and maintained below its neutral level until 2007. During this period, investors’ risk appetites significantly increased. The result was a prolonged period of buoyant money and credit expansion.

In the three years to December 2007, the ratio of the broad money supply, M4, to nominal gross domestic product (GDP) rose by 22 per cent. A comparable increase has occurred only twice since 1945 – the early 1970s and late 1980s. Both episodes were characterised by rampant demand and output growth, a widening current account deficit and a subsequent large rise in inflation. These “Barber” and “Lawson” monetary booms – named after the chancellor of the day – were followed by damaging recessions. The UK has now had an “MPC boom”, again with painful consequences

The MPC discussed rapid money and credit growth at its meetings in 2006 and 2007 but played down the dangers . Members argued that the build-up in money balances was concentrated in the financial sector so would not result in a significant boost to demand for goods and services.

While economic growth has been strong, it has been lower than in the early 1970s and late 1980s, implying less pressure on supply capacity. The MPC view, however, neglected the possibility that “excess” money would flow across the foreign exchanges, leading to a sharp decline in sterling, thereby exacerbating upward pressure on import costs. The concentration of liquidity in the financial sector, accompanied by a large rise in overseas sterling deposits, increased this risk. The effective rate has fallen by 13% since July 2007 – similar to the “pound in your pocket” devaluation of 1967. In addition, monetary buoyancy may have contributed directly to rising inflationary expectations.

The upshot is that official neglect of monetary warning signals has once again been followed by an unexpectedly large rise in inflation although details of the transmission mechanism differ from earlier episodes. In effect, loose domestic monetary conditions have accommodated or even supplemented the inflationary impact of rising global costs.

How should policy now respond? Some commentators have urged the MPC to “look through” the current overshoot on the grounds that a weakening economy will return inflation to target in two years’ time. Even if this were assured, the argument neglects the MPC’s requirement to meet the target “at all times”. While policy actions have their greatest impact at longer horizons, they also affect shorter-term prospects so it is wrong to focus solely on where inflation may be two years ahead.

The recent painful tightening in credit market conditions should, in time, contribute to much slower monetary growth. The headline CPI rate, however, is set to rise significantly further and firms and employees may build a higher trend level of inflation into their price- and wage-setting behaviour.

The danger of inflationary expectations becoming dislodged from the 2% target is greater now than in April 2007 when Mervyn King wrote his last exculpatory letter. In 2007, CPI inflation returned to target four months after reaching the 3.1% threshold. Now, it is likely to remain above 2% until late 2009, barring a significant decline in commodity prices.

This means that interest rate doves who think there is scope for further monetary loosening currently are misguided if they wish the Bank to restore its anti-inflation credentials. Any future reduction must be conditional on evidence of a moderation in monetary expansion and inflation expectations. The short-term economic pain implied by such a policy is outweighed by the potential costs of failing to return inflation sustainably to the 2% target over the medium term.

An edited version of this article appears in today's Financial Times.