In a recent address at a central banking conference in South Africa, Huw Pill, Chief Economist of the Bank of England (BoE), expressed support for keeping interest rates at their 15-year high of 5.25% for an extended period, rather than pursuing additional rate increases.
Nonetheless, Pill emphasised that the BoE’s main priority is to implement sufficiently restrictive measures for a significant period to achieve its 2% inflation target. He observed that core inflation persists at troubling levels, with no apparent signs of diminishing.
This ongoing pressure has led financial markets to expect a potential rise in the BoE’s policy rate to 5.75% by year-end, followed by subsequent decreases in 2024 and beyond.
Pill, a consistent advocate for higher interest rates, having expressed this view during the past 14 meetings of the BoE’s Monetary Policy Committee (MPC), is now signalling a preference for a plateau, likening it to South Africa’s famous Table Mountain. If a majority of MPC members share Pill’s evolving position in upcoming meetings, it would mean maintaining the current 5.25% interest rate for an extended period, possibly well into the second half of 2024 or beyond.
For those closely monitoring broad money trends, especially the strong relationship between broad money growth rates, nominal national income and price levels, Pill’s comments are indeed encouraging.
The Institute of International Monetary Research (IIMR), which has repeatedly warned against overly restrictive policy rates amid declining inflation due to significant broad money contraction, continues to recommend a halt in further interest rate hikes to avoid an unnecessary deep recession.
Pill commendably acknowledged the potential risk of high rates causing ‘unnecessary damage’ to the economy, admitting that the full effects are yet to be seen, as households and businesses are still adjusting their spending behaviors. With broad money continuing to contract, further declines in asset prices are probable, increasing financial stress.
These concerns coincide with the Institute’s viewpoint and have contributed to public dissatisfaction with the Bank, as evidenced by record low satisfaction levels since the first Public Attitudes Survey on inflation in 1999.
While it is entirely appropriate to criticise the Bank’s initial misdiagnosis and sluggish response, the fundamental problem lies in the dominance of the New Keynesians’ three-equation model in the Bank of England’s monetary policy decision-making process. This model overlooks the role of the quantity of money in circulation, hindering the Bank’s ability to understand the economic effects of unconventional monetary policies like quantitative easing (QE).
The impact of large-scale asset purchases by the BoE on asset prices and the price level depends on the underlying state of the banking system and economy at the time of implementation, as well as the nature of the economic shock. What was necessary in 2009 to prevent a deflationary spiral only fueled the inflationary fire in 2020-21.
Despite signs of an overheating economy in late 2020 and early 2021, the Bank relied on inflation expectations to alleviate concerns about medium-term inflation. As recently as May 2022, Governor Bailey attributed the inflation overshoot to ‘unprecedented’ external shocks, seemingly ignoring that inflation started rising well before the outbreak of war in Ukraine. This reliance on the ‘transitory inflation’ narrative has led to inaccurate inflation projections for 2022 and 2023.
The prevailing criticism of the Bank’s inflation forecasting model centres around a significant omission: the neglect of the importance of money. Unfortunately, these deficiencies become glaringly obvious when the economy reacts to substantial changes in broad money supply growth. For instance, the BoE-driven 15.4% growth in broad money during the year leading up to February 2021 – a level three times the long-term average consistent with 2% inflation.
The weakness of these models is particularly evident in the Bank of England’s research and forecasting performance in 2021. Fluctuations in asset markets often precede developments in labour markets, serving as an early warning system for inflationary risks. Paying more attention to variations in broad money growth could potentially have mitigated much of the inflation surge experienced since 2021.
Governor Bailey’s statement in June, pledging to do ‘whatever is necessary’ to bring inflation back to the 2% target, recalls Mario Draghi’s determined declaration of ‘whatever it takes’ in 2012. This comparison seems to suggest a tendency to continue ignoring the warnings from monetary data.
A recent speech by Silvana Tenreyro, who served as an external member of the MPC for six years until July 2023, stating that the quantity of money is not a factor in any channel, encapsulates the prevailing mindset within the Bank.
The current surge in inflation underscores the need for a comprehensive rethink on inflation management; one that must include consideration of monetary aggregates. The MPC’s prolonged neglect of the consequences of its excessive broad money growth in 2020 and 2021 necessitates that policymakers acknowledge the performance of current inflation forecasts grounded in monetarist principles, as opposed to the Keynesian-based models they have traditionally depended on.
Huw Pill’s acknowledgment of the warning signs emanating from the ongoing contraction in broad money growth and his call for a temporary halt in policy action is indeed wise. The challenge now is to persuade the remaining members of the MPC to align with his position.
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