This month, the Bank of England will celebrate 25 years of independence. For the past quarter of a century it alone, and not Her Majesty’s Government, has been responsible for setting interest rates and controlling the amount of money circulating in the economy.
But this is no time to throw a party or mint a new coin (or even an NFT). With the UK sailing into the teeth of a brutal cost-of-living crisis, the Bank’s leadership would be much better advised to use this milestone to step back, reflect, and jettison some of their very dangerous ideas about inflation and its role in our economy.
The Bank has already failed in its core mission to keep prices under control: according to the Consumer Price Index (CPI), inflation jumped to a 30-year high of 6.2% in February. In light of that, some economic commentators are already calling for a fundamental overhaul of its mission.
However, there is no point in doing this unless and until the Bank’s leadership accept that not only has their response to the crisis been fundamentally mistaken, but that it is actually contributing to the very problem they are meant to be solving. In short, they have defined inflation wrong.
Inflation, properly understood, is an increase in the amount of money and credit circulating in the economy. It is not price rises. These may be a consequence or symptom of inflation, but that is quite different. Yet the Bank itself seems to define inflation in terms of price rises.
This might sound like splitting hairs; after all, it is the cost of goods at the till, rather than the grand economic theory, that understandably preoccupies consumers.
But it is actually fundamentally important. Under the Bank’s definition, its own money-printing interventions are only one contributory factor to ‘inflation’. Under the proper one, they are the root cause of the entire problem.
This has political consequences, because it is the Bank’s understanding that legitimises the fallacy of so-called “cost-push inflation”. This is the idea that rising wages feed back into rising prices into a negative feedback loop, and leads to the grim spectacle of Andrew Bailey, the Bank’s governor, urging people not to demand pay rises even as the cost of essentials spirals.
Such an approach is politically toxic (good luck to the politician who tries it), and all but unworkable. Successive governments spent the 1970s trying and failing to impose wage controls on British workers in order to try and bring inflation down, and they failed time and again. They will fail now as well.
(For context, between 1970 and 1985, the average UK inflation rate (using the Bank’s definition) was 11.48%, peaking at a whopping 24.24% in 1975.)
But the idea that controlling wages will deal with inflation is also just wrong. To understand why, think about it in terms of your personal budget. If the cost of essentials such as food and heating goes up, the money left over for discretionary spending on entertainment and recreation goes down. This puts downward pressure on the price of those goods, and the average price level should be roughly stable.
The only way that prices can rise across the board, even as the real purchasing power of household incomes shrinks, is if money is flooding into the system faster than the supply of goods and services is expanding to meet it. And who decides how much money enters the economy? The Bank of England.
This process won’t necessarily be uniform: the money enters the economy through specific sectors, the short-term beneficiaries in line with the Bank’s ‘targeted’ interventions. But over time, it filters out and results in higher average prices for you and me.
Even so, we should not overlook the dangers of the distortions Bank interventions can cause.
Central banks generally aim to maintain a low, consistent level of inflation (as they define it), but a superficially acceptable average can disguise huge variations. Newly created money can end up flowing into those sectors with already high demand and compounding increases in relative prices that might have been driven by market forces.
Take 2008, the last time prices rose significantly, as an example. Hard-pressed consumers suffering under the financial crisis saw an average rise of 3.3%. The Bank may have been reassured that this was only 1.3% above their 2% target.
It was cold comfort to consumers that year that electronics were relatively cheaper (which is not the same as being actually cheaper, as you’d expect with even demand) when the cost of necessities were rocketing. And naturally, when inflation drives up the cost of essential goods it hits the poorest hardest.
That’s before we even get to the instability Bank interventions can cause. From 1993-2007, for example, average price increases were broadly stable and close to target, but below the headlines money printing by central banks saw flows of freshly minted cash inflating asset prices and making some sectors look falsely profitable.
We have this process to thank for both the Dot Com bubble, which burst in 2001, and the financial crisis in 2008. In the case of housing the consequences of decades of malinvestment are still being felt, as banks pump credit into the market much faster than wages can possibly rise to keep up.
This process hasn’t stopped. The Bank has expanded the money supply at an unprecedented level. Over the last 13 years it has opted to print £895bn through its programme of quantitative easing, buying £875bn of government debt along with £20bn of corporate bonds. Some £450bn of this programme is just since the pandemic.
The capacity for these programmes to create malinvestment on a staggering scale is a clear and present danger to the British economy. City veterans are already warning that ‘markets are addicted to QE and central banks have become very nervous about removing the drug’.
What the ‘masters of the universe’ need to accept is that a nine-person Monetary Policy Committee, no matter how learned and able its membership, will never be able to foresee all the potential unintended consequences of artificially tinkering with interest rates and the supply of money in the economy. The dangers of their getting it wrong are both enormous and borne by the poorest in society.
Better by far for the Bank to use this anniversary to embrace its humbler historic remit as a lender of last resort for troubled banks – and leave prices to the market.
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