15 December 2021

As inflation bites, the Bank of England is running out of opportunities to restore credibility


It’s not often I agree with the International Monetary Fund (IMF), but their latest warnings on the risks of inaction from the Bank of England could not have been more timely. The jump in consumer price inflation to 5.1% in November has already taken it well above the figure of 4.5% that the Bank was predicting as recently as last month.

The best hope is that inflation settles around these levels, then drops sharply from mid-2022. But the credibility of the Monetary Policy Committee (MPC) is on the line if they fail to act now to keep inflation, and inflation expectations, in check.

The biggest contributor to the surge in inflation in the UK, as elsewhere, is still the jump in global energy prices, which are now levelling out (oil appears to be settling between US$70 and US$80 per barrel). But the CPI excluding food and energy still rose by 4% in November, twice the MPC’s target of 2% for the headline rate.

Even more importantly, the huge amount of monetary stimulus from quantitative easing (QE) means that even if energy prices drop back, inflation may simply pop up elsewhere. There are already signs that cost and price pressures are spreading, and growing evidence that expectations of higher inflation are becoming entrenched in the economy.

Clearly, the Bank cannot control short-term movements in inflation, or influence global oil prices. No-one is suggesting that it should try. Nonetheless, it can reassure households and businesses that it is serious about bringing inflation back down again in the longer term.

Any increase in interest rates will have some real consequences, but these will be small, while the economic, social and fiscal costs of a prolonged period of higher inflation would be much greater.

In particular, a 0.15 percentage increase in official rates (to 0.25%) would have little impact on savings or mortgage rates, which have already risen in anticipation of higher rates next year. And it would add less than £2 billion to the annual cost of servicing UK government debt.

You also have ask if the time for action is not now, then when? Since the MPC’s November meeting, inflation has risen further than expected and the labour market has continued to tighten, despite the end of the furlough scheme. These factors knock out the excuses that the majority of members gave for doing nothing last month.

The new uncertainty created by Omicron is not a great reason for inaction, either. Omicron seems more likely to add to inflation pressures, by further disrupting supply chains, than to reduce them by dampening demand. The job of managing short-term shocks to economic activity is best left to fiscal policy.

Indeed, the Bank’s own quarterly survey of public attitudes to inflation, published earlier this month, showed a further decline in satisfaction at how well the MPC is ‘doing its job to set interest rates to control inflation’. (Though, to be fair, the Bank still had a net approval rating that would be the envy of many politicians!)

These same factors are already likely to prompt the central bank in the US (where inflation has hit 6.8%) to accelerate the pace at which it tapers its own asset purchases. And if the Bundesbank were still setting interest rates for Germany (where the national measure is now 5.2% and the EU measure 6%) it would probably be taking action now too.

Other central banks have done so as well. For example, the Reserve Bank of New Zealand has raised rates, twice, to 0.75%, to help ensure that inflation returns to the 2% mid-point of its own medium-term target. The labour market is tighter in New Zealand than in the UK, and GDP higher relative to its potential, but we should at least be at 0.25% already.

At the bare minimum, the MPC should confirm tomorrow that quantitative easing will end this year with the completion of the current programme of asset purchases.

In short, the Bank of England is running out of opportunities to restore credibility. A rate hike tomorrow would still surprise the markets, even after today’s inflation data. But that would surely now be a good thing.

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Julian Jessop is an independent economist.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.