For a decade or so, nearly all commentators were mesmerised by the self-reinforcing genius of inflation-targeting, Bank of England independence, and those famous fiscal rules.

Well, how about adjusting or even abandoning our current two per cent inflation target and letting a moderately higher level of inflation help smooth along the painful process of deleveraging?

Ridiculous? Heresy?

Well it is almost precisely what Olivier Blanchard, the chief economist of the IMF, floated in a paper published this month by the IMF, which argues why an inflation target of four per cent could be superior than a two per cent target. Put simply, an inflation target of four per cent minimises the risk of deflation and the need for near-zero interest rates. 

Of course, it is also the first step towards uncontrollable inflationary spirals, rack and ruin, and using a £10,000,000 note to buy your copy of The Economist. That such a policy is being contemplated at the IMF, will also mean that it’s being chewed over at the Bank of England and the Treasury.

Of course, there is no incentive to admit it, because markets will react to any perceived weakening in the Bank’s anti-inflationary resolve. Though it’s worth noting, under the terms of the 1998 Bank of England Act, that the annual setting of the target is made by the government.

So do any of Messrs Darling, Osborne or Cable take Professor Blanchard’s idea seriously?

Well we have an important moment for George Osborne tomorrow. He is giving the prestigious Mais lecture at City University. It’s a lecture where in 1981 Geoffrey Howe launched ‘the Fight against Inflation’ with a background of inflation in double figures.

And then in 1984 Nigel Lawson marked a change of direction, emphasising the centrality of monetary policy in managing demand. Blair and Brown also gave high profile lectures.

In recent weeks, George Osborne and David Cameron have been talking about getting Mervyn King involved in tax and spending policy, and I mentioned the other day why in these strange economic times it might be a good idea
Mervyn King said that he ‘didn’t understand the proposal’.

But this morning, at the Treasury Select Committee, King made this reference to the possibility of inflation remaining high. ‘There are risks there could be further upward movements [in inflation], whether it be commodity prices or other changes in indirect taxes, who knows?’, he said.

So unwitingly Mervyn King seemed to be accepting the invitation to get involved in fiscal policy, with a clear hint around expectations of a further rise in VAT.

VAT at 20 per cent is the whisper in Whitehall and in industry. It would raise £12bn per year, and industrialists argue that it would also help in the ‘grand rebalancing’ of the UK economy away from debt-fuelled consumption towards investment.

Now I’m not expecting a VAT or inflation target change at the Mais lecture from Osborne tomorrow (though Labour is basing at least part of its election strategy on the Conservative history of raising VAT), but the shadow Chancellor will have to put some flesh on policy bones.

In truth, this is likely to prove the end of an extraordinary 11-month experiment. Right now though, understandably, the Bank of England needs to keep its options open. If the economy worsens, they want to be free to increase purchases of government bonds. If it’s better than expected, it may push on with beginning to withdraw this stimulus.

I’m convinced that at Threadneedle Street, they were shocked by the limpness of Britain’s exit from recession. They have been running their big computer model in the past weeks. When it reveals new economic forecasts next Wednesday, we are likely to see a marked downgrade to Britain’s economic prospects.

Today’s decision does mean that for the first time since quantitative easing began 11 months ago, the Bank of England will not be engaged in the purchase of gilts this month. We will now see what price real buyers want to charge the UK government to borrow money.

As Ed Conway at the Telegraph points out, the Bank appears to be convinced that the stock of £200bn of asset purchaes will continue to support the economy, even if that number is not being added to.

Certainly it is more expansionary than if the Bank of England began the tricky process of reversing quantitative easing by selling its stock of government debt at the exact same time as the government sells a further £200bn debt it needs to fund its operations next year. That process is what we might begin to call quantitative tightening.

Britain has never quantitatively tightened before. In theory it should work like QE but in reverse. It should destroy money instead of creating it. It probably will not begin before the election but all of this begins to explain why Cameron and Osborne have been talking (to me and others) about involving the Bank of England in decisions on fiscal policy, ie on tax and spending decisions.

In theory, the stock of £200bn of government debt owned by the independent Bank of England, could be dumped on the markets as quickly as they were acquired.

In that scenario, financial markets would have to absorb about £400bn of government debt during 2010 and 2011. Of course that is not going to happen. One option is that the BoE will never sell the government bonds it has bought with invented money, and instead issue new short term debt.

It makes the prospect of a 2010s reincarnation of the Ken and Eddie show rather intriguing.

The George and Merv Show will be a far more painful bit of theatre.

Nothing need go pop, unless inflation were to remain stubbornly high. Then the Bank would have to practise the inexact science of deciding the appropriate pace of QT, of asset sales, and interest rate rises.

Perhaps it can be achieved through rate rises alone. Merv would want to know how much debt George wants to sell but Merv could not decide monetary policy in a private meeting with George, because it’s supposed to be decided by a nine-strong independent committee.

Far from Mr Osborne determining monetary policy, Mr King may be unusually influential over tax and spend.

QE meant monetary policy was fiscalised. QT could monetarise fiscal policy. Navigating through this swamp without sacrificing either growth, Britain’s credit rating or the independence of the Bank of England, will not be easy.

I pondered this while the IFS revealed perhaps the most important non-party document of the pre-election period. Its Green Budget, released today, is thicker than the actual budget document, and an invaluable guide through the maze of public finance posturing.

My view of it is that it is beginning to expose the almost irrelevant differences in economics that underlie the current fierce public spending politicking.

The “debate” is about tax and spend in the period starting this April (2010/11) to 2015/16. The tax increases and spending curbs announced over the last three Budget statements imply a fiscal tightening of 4.1 per cent, or £57bn in today’s terms.

The IFS thinks that £13bn more of additional tax increases or spending cuts would be sensible in this timeframe to defuse the debt danger. Remember with elements of health and schools already “protected” and debt interest payments and benefits surging, some departments are already facing savage 17 per cent cuts.

So where would the additional money come from? The spectre of fundamentally higher taxes and/or acute benefit or tax credit cuts looms large in this analysis.

The IFS take so far seems fundamentally supportive of the Conservative promise to cut faster than Mr Darling’s legally enshrined plan to halve the deficit over the next parliament. But the IFS also undermines the recent Conservative debate on when to start cutting, which began with my Davos interview with David Cameron.

Last week, to me, Mr Cameron said that the Tories’ deficit reduction plan “must start in 2010″, even if Britain has relapsed into recession. He did say, even then, that the precise scale of the cuts would be coordinated with the Bank of England. He spent the next couple of days emphasising that the cuts would not be “particularly extensive” and “not swingeing”.

The IFS position, and that of Barclays Capital, is that now is the wrong time to start further cuts at all, pointing out that “the UK is withdrawing its temporary fiscal support for the economy earlier than almost all other G20 countries”.

So the message from the IFS is: don’t cut now but plan credible larger cuts for the entirety of the next parliament. It undermines both Labour and the Conservatives.

It suggests that the Tory “cuts now” agenda is misplaced. And the Labour sluggish post-election deficit reduction plan is also misplaced. And it’s a further feather in the cap of Uncle Vince Cable.

* The really scary thing was the macroeconomic forecast from Michael Dicks of Barclays Capital, which accompanies the Green Budget. More on that tomorrow.

Professor Gregg is not one of those academics prone to hyperbole. He is a former government adviser, but nobody would doubt his independent credentials.

So a measure of unemployment is now going down, the wider ILO measure which lags by a month is stabilising employment is up.

Public sector employment is up, of course. But private sector employment is also up. Vacancies are up. Oh yes, before you start on this being a Christmas temporary boom, the numbers are all seasonally adjusted, so this takes that into account. Much of the increase is driven by a huge surge in part time employment.
 
So I was wondering why at a gathering of the economic establishment last night, the Bank of England governor, Treasury officials and independent experts were rather chirpier than I expected. (I’d put Mervyn King’s mood down to Aston Villa’s surge up the league tables).
 
Now we are beginning to know why.

As I pointed out in August, there had already been a growing economic cluedo about the “phantom jobless” over why employment had not fallen much further given the calamitous contraction in the economy.

Mervyn King had mentioned this phenomenon to me in August. The Bank of England produced this graph last month:

But it is astounding that any measure of unemployment would actually be falling by now.

If, as we expect, the economy has just about started to grow, it would be virtually unprecedented to see unemployment begin to fall at the same time.

The peak in unemployment normally occurs at least six months after a recession ends. So 18 months into our worst recession in living memory we have a previously unheard of turn in the labour market.
 
So what’s causing it, and can the government take credit for it?
 
Unemployment experts point to the fact that a huge chunk of the jobs lost in previous recessions, were older workers who were funnelled into early retirement.

That is more difficult now. There has been a sizeable rise in part time working that might have been aided by tax credits. Workers, like the shop floor workers that I met at Honda, are more willing to cut their hours than see their colleagues’ lose their jobs. And perhaps the government have kept on to public sector jobs more than in previous recessions.
 
However two dark clouds loom.

Firstly youth unemployment is still rising. However many people are unexpectedly keeping their jobs, the state of those trying to enter the labour market is chronic.

Also the fear might be that the job shedding we have not had will simply be delayed into next year – that there will be a painful second leg of joblessness. Productivity is also tumbling in the UK, whereas it has surged in the US.
 
At the Bank of England and the Treasury, they will see some vindication in their economic strategies so far. 

Yes they may be partly to blame for the downturn. But the extent of unemployment has undoubtedly been contained by their actions.

Now to be absolutely clear this is an entirely different, new, and secret form of funding from the myriad of government support schemes for British banks.

The fact of this additional temporary loan worth at peak as much as the combined annual budgets for defence and transport emerged in a memo from the Bank of England to the Treasury Select Committee. It was all repaid by January of this year.

‘Tough stuff’ and ‘a dire emergency’, is how Bank of England Deputy Governor Paul Tucker described this, and to be fair to him there was rather good reason to keep this support secret, at least initially.

The Northern Rock run a year earlier was triggered by leaked news of exactly the same type of loan to the Newcastle-based bank.

In the aftermath, Mervyn King argued for and got changes to City regulations, to allow what the Bank itself refers to as ‘covert operations’.

Vince Cable has been tabling parliamentary questions about why it took a year for the news to come out, saying that the public and parliament are ‘being treated like children’.

It’s Lloyds shareholders who are suing over the bank’s purchase of HBoS who might be the most interested in this revelation. The Government, the Bank of England, and knew about HBoS’s huge emergency loan when the deal was voted on.

Channel 4 News has been told by the City minister Lord Myners that the Lloyds board knew about it too. ‘The board of Lloyd’s were fully in the picture,’ Lord Myners told us tonight. But the shareholders did not, but for a vague reference from page 224 of the takeover prospectus:

“In the current market conditions, central bank and government facilities are an important tool in the liquidity management solutions for banks, including HBOS, and are in addition to other funding sources available to HBOS, such as retail and corporate customer deposits… As with many other banks, HBOS makes use of a number of these arrangements to assist with its funding and liquidity management… The HBOS Group expects that it will substantially rely for the foreseeable future on the continued availability of these government sponsored arrangements, including central bank liquidity facilities (such as those offered by the Bank of England) as well as HM Treasury’s guarantee scheme for short- and medium-term debt issuance…”

‘It may well be that the Lloyds shareholders have good reason to believe that they were seriously misled,’ says Vince Cable.

Now it doesn’t end here either. Buried on page 148 of the Lloyds prospectus for its megacapital raising  is the news that it is still in receipt of around £165 bn in support from various official schemes. So it is really very likely that the loan which was ‘repaid’ by HBoS was actually just rolled into the Special Liquidity Scheme alongside mountains of HBoS toxic commercial property waste.

The Bank of England would argue that the actions stabilised a situation without the panic of the previous year. and the fact markets are stable enough to release information shows that there efforts are working. What we do now know is that HBoS and RBS were even more bankrupt in October 2008 than had previously been thought.

* Full Disclosure: Long ago, my father used to work for TSB, and bought me a small number of shares, which are now shares of Lloyds Banking Group. I don’t generally own or actively trade shares. These are a result of my father’s former employment.

The Bank has just voted to increase its money creation exercise to £200 billion. A £25 billion increase is a little less than had been expected.

The Monetary Policy Committee is marginally less worried than thought about last month’s shock news that the economy is still in recession. It may be marginally more worried about the prospective inflationary consequences of its epic money creation scheme than the City believed.

What we can say now is that Britain is the undisputed QE world champion, that this policy has been pushed further than any developed country in modern history.

So ‘is QE working?’ is now a £200 billion pound question.

Passing judgement on quantitative easing (QE) is a bit like divining the impact of water fluoridation on Britain’s dental standards. You can see some sparklier teeth in Britain’s credit markets, but is all of that really down to the Bank’s extraordinary experiment?

The most tangible impact has been on the market for government debt, where the Bank of England has gobbled up the extra government debt, lowering the price the Treasury pays by over a full percentage point.

Today’s news saw a sell-off in that market, with that interest rate increasing by 0.1 per cent. The markets clearly see the fact that there will be “just 25 billion” of QE in the next three months, as a high watermark for the policy (QE to date has been running at £25bn every month).

David Cameron warned in his Tory party conference speech that QE had to stop at some point, and only then would we see the true demand for British government debt. We are now close to that point.

So what’s it achieved? Well there has been a flurry of larger companies that have bypassed the stodgy banks, by raising money from capital markets to reduce bank debt. Typically they issue corporate bonds sold to the likes of pensions and insurance companies. This is part of the story of how QE has helped the economy.

But it is impossible to say what proportion of this extra lending has come as a result of the Bank’s experimental policies and what has come from a general improvement in sentiment.

So QE has disproportionately helped larger companies rather than smaller companies. It has helped banks too. It may have helped pump up asset prices around the world. And, indirectly it has clearly contributed to a helpful fall in the value of sterling. Not quite a devaluation, but not a million miles away from it either.

The donkey has been kicking a little in the past few days. There have been some strong manufacturing and services sector survey numbers earlier in the week. But there were more bad numbers out today.

So the question remains about when this policy gets unwound. When does quantitative tightening begin? Well it’s never been done before. And the Bank will want to be completely certain that the donkey is alive and kicking, before they remove its tail.

As part of the QE arrangements the Chancellor and the Bank of England Governor Mervyn King swap letters. Normally it is an eminently forgettable spot of legalese.

Not this time.

The Chancellor chose to use the letter to issue what can only be termed ‘a gentle prod’ aimed at the Bank of England. Mr Darling appears to want the Bank to use QE to lend to companies directly by buying so-called commercial paper. This hasn’t happened so far.

Then, in January, came Bailout 2.0, which we were told would be a bailout not of the banks, but of the economy. That bailout was to enable the banks to continue lending to prospective homeowners and to businesses.

And now we have Bailout 3.0.* Incredibly, the extent of actual taxpayer funding into these two banking giants will be larger than the first bailout, which rescued them from collapse. £40bn more.
This will be spent on banking shares that have fallen in price since the last tranche was bought. RBS, two years ago the sixth biggest bank in the world on some measures, will now be 84 per cent owned by the state.

To be fair to the Treasury, this outcome was indicated back in January, though it had not been expected that all the £25.5bn would be needed up front. There’s also an incredible tax break, worth billions for RBS, which reflects their ability to charge losses against future tax bills. It must have caused the government accountants a headache.

What really has changed is that the extent of the guarantees: the so-called contingent liabilities have been reduced markedly. Lloyds have sidestepped the government’s toxic waste guarantee scheme, so £260bn of HBOS’s rotting commercial property and mortgage assets will now be dealt with by the private sector. The process of due diligence has also shrunk the RBS guarantee from £325bn to £282bn.

I had previously pointed out that the APS was seen internally as the biggest government contract signed since the Lend Lease arrangements with US forces during world war two. As Lloyds exits, this may no longer be the case. Indeed having gained £2.5bn for a nine-month insurance policy that did not pay out a penny, Lord Myners may wish to start up shop as an insurer if he leaves government next year.

So arguably the situation is better than the worst-case scenario envisaged by Bailout 2.0. The taxpayer no longer has to worry about HBOS’s toxic waste dump. But more money more quickly appears to be seeping into RBS.

The crucial difference is that this happening at a time when we are told there is no money for anything else. No money for public sector pay. No money for other industrial or consumer stimuli. Small wonder that the government shot George Osborne’s fox by banning cash bonuses to anyone at these two banks earning above £39,000.

*The biggest hedge fund in Britain, is how Robert Peston referred to this deal. The government is borrowing money at 3 per cent to buy shares in banks. It’s the classic story of leverage that funded the champagne lifestyle in Mayfair.

Of course, the next leg of this analogy is to point out that the Treasury’s deficits are actually being funded by the Bank of England, which in turn is creating the money out of thin air. No hedge fund has those powers.

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This morning revealed the reality that the Bank of England nearly voted for even more creation of its funny money.

Three members of the nine-member committee that decided our interest rates, and now conjures magic money at a keystroke, felt that this month’s decision to pump £50bn into the economy was too small.

Until now decisions on this highly unconventional policy have all been unanimous. More importantly, it suggests that the Bank of England is far from finished with this policy. All that means it is too early to think of rates going up in the near future, even given the stickiness of yesterday’s inflation figure.

Governor Mervyn King was also outvoted by his committee. Remarkably, he was outvoted not for being too hawkish (i.e. worrying more about inflation) but because he was too dovish. This is a first.

So King is more worried about the risks to the UK economy than the rest of the monetary policy committee. In Bank-speak: “The potential adverse consequences of adding another large monetary stimulus might be less severe than the possible costs of acting too cautiously.”

Professional economists are all over the place in trying to predict what the Bank does next. And today’s minutes show that the Bank itself is increasingly unpredictable. This is not necessarily a bad thing. This is how we depicted QE before it happened in January -

We are conducting the biggest economic experiment in British history, so don’t expect much predictive power from the economist. But the UK is pushing the policy of printing money much further than any other comparable country, and our chief money man wants to push it yet further.

The most tangible result, though, is on the government debt markets. The Bank broadly agrees with this intriguing IMF staff report suggesting that QE has lowered the interest rate paid by the government on its debts by as much as 0.4 percentage points.

This is huge. It is one of the reasons why the DMO chief told me in May that the credit rating downgrade feared by David Cameron might have only an “imperceptible” impact on Britain’s funding costs.

Remarkably we are heading towards £200bn worth of government debt being bought by the Bank of England. So what is the total issuance of UK gilts 2009-2010? £220 billion.

So Cameron should not be worrying about us going bankrupt any time soon. We have a ready buyer for our government debt right now. It’s what happens after that’s a little hazy.

The banking system is still in a bad way and it may take some years for it to be “weaned off very large public support”. The recovery is likely to be sluggish and protracted. And they could not tell when unemployment would stop rising.

Amid the entrails of uncertainty, however, was a perceptive piece of statistical analysis and a gleaming ray of light on those jobs numbers.

In November, I was told in a private briefing by the then Secretary of State for Work and Pensions, James Purnell, that the Government was hopeful that for a given level of downturn in the economy there would be less unemployment in this recession. He put that down, obviously, to the Government own programme of activist labour market interventions, such as jobcentre plus, alongside Britain’s traditionally flexible jobs market.

On the first point, so far the Purnell’s private predictions have proven strikingly accurate. Even given the pain of 2.44 million official unemployment, the bald fact is that unemployment should be much higher given the calamitous collapse in the economy.

In the five quarters of this recession, the economy has contracted by a whopping 5.7 per cent, and employment, measured by the Labour Force Survey has fallen by 1.7 per cent. Yet in the 1990s recession half the contraction (-2.5 per cent) led to double the fall in employment (-3.4 per cent). In the 1980s a 4.7 per cent economic contraction led to a 2.4 per cent fall in employment.

Mervyn King talked about this in answer to a question from me today. His answer? That perhaps Britain’s flexible jobs market has allowed the reduction in demand for goods and services to be accommodated by moves to part-time working and pay cuts, rather than job losses.

Another theory, in fact it is my own, is that perhaps we have not yet seen a huge round of public sector job cuts. Given the current political talk about slashing spending, perhaps the “phantom jobless” will reappear in the next year or two. And then there’s the thorny issue of productivity, but more on that later in the week.

For now it’s is some unlikely good news to be gleaned from some bad unemployment numbers, and that Oracle of Threadneedle Street.