Today, the Bank of England left interest rates unchanged at 5.25%. This was in line with expectations. In my view, the Bank of England should have eased policy and cut interest rates to 5% with a view to reduce them further. The economy is fragile, inflation has decelerated sharply and monetary policy is already too tight.
Two wrongs do not make a right. The first wrong was that the Bank of England kept monetary policy too loose as inflationary pressures built. The second wrong is that the Bank has overcorrected by raising rates too much. Unfortunately, the Bank has also not been particularly good at either reading the outlook for the economy, or communicating clearly its policy thinking.
The Monetary Policy Committee (MPC) voted 8-1 to keep rates unchanged today, with one member voting to cut rates. This was a change from last month, when the voting was 1-6-2, with two members still strangely voting for a hike then and one for a cut.
Three years ago I asked which ‘p’ would the rise in inflation be? Would it pass through quickly, persist, or become permanent? The Bank wrongly thought inflation would pass through quickly, calling the initial rise in inflation transitory. Instead, I thought inflation would persist, and it has.
But the good news is that two factors that triggered the recent surge in inflation have been reversed. These were the supply-side shocks linked to the pandemic and to the war in Ukraine, alongside inappropriate monetary policy which was then too loose.
Inflation peaked in autumn 2022 at 11.1%. This week, there was further evidence of the deceleration in inflation, with the annual rate of inflation falling to 3.4% in February. If one looks at the recent trend, this strengthens the case for the Bank to ease. Significantly, in recent months, the pace of annual inflation has been negligible at 0.3%. While over the last half year, the annualised increase is only 0.5%. For some time now it has appeared likely that inflation would dip below the 2% inflation target before summer.
The minutes that were released today from the MPC meeting gave little indication that the Bank will be rushing to cut rates anytime soon. Even though the surge in inflation was not explained by wages, the Bank has been concerned about second-round inflation effects, and in particular wage growth. Today’s minutes suggest that some members of the MPC still remain concerned about wage growth as well as service sector inflation, which remains elevated at 6.1%.
The minutes also noted that business surveys are ‘consistent with an improving outlook for activity’. That may be the case, but the economy is still very sluggish, as evidenced by the fact that it was in a technical recession at the end of last year. The economy did bounce in January, and thankfully as inflation falls, real incomes will rise, boosting consumption and this should boost consumer and business confidence.
However, the full impact of previous monetary tightening has yet to feed through fully. Bank lending and monetary growth is sluggish and those people who are remortgaging this year, will be doing so at far higher rates. This adds to the case for policy easing. If monetary policy remains too tight, then the danger is a pyrrhic victory over inflation.
Moreover, it is not just policy rates, it is also the Bank’s actions in the gilt market, where they are reversing quantitative easing by reducing their holdings of gilts. While the Bank views this as a purely technical exercise, it will keep yields higher than they would otherwise be.
Eventually, I expect the MPC to shift tack. Perhaps they need to see more evidence of a fall in core inflation, which excludes food, fuel, alcohol and tobacco. This rose at an annual rate of 4.8% in February versus 5.1% in January. The trouble is that monetary policy has moved from being forward looking to being coincident, set based on the latest data, even though it may take twelve to eighteen months to feel the full impact of monetary policy changes. I still expect the Bank to cut rates before the summer and to ease rates to around 4.5% by year-end.
It is still unclear where inflation will settle. It has been interesting to see how global factors were often blamed by the Bank for triggering the recent surge in inflation, yet the previous impact of global factors in keeping inflation low often went unremarked upon. Over the last quarter of a century, four global factors contributed to low inflation: globalisation, low wage shares, technological change and financialisation. Of these, two have changed in the wake of the pandemic, with fragmentation replacing globalisation and wage shares creeping higher, sometimes despite low productivity. This suggests that inflation may settle at a slightly higher rate than its pre-pandemic level.
While this must not stop the Bank easing policy and cutting rates now, it should be another factor ensuring that we do not return to the disastrous cheap money policies that characterised much of the previous decade. Cheap money led to asset price inflation, led markets to not price properly for risk, triggered a misallocation of capital and contributed to the recent surge in inflation. Cheap money wasn’t just low interest rates but also the expansion in the Bank’s balance sheet through quantitative easing. As a non-commercial buyer, the Bank drove yields lower, helping the Government fund its budget deficit and distorted bond yields.
We can’t rely on monetary policy to be the shock absorber for the economy in the way it has been before, but there is a need for interest rates to fall, and soon.
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