The writer is UK economist at Morgan Stanley
With inflation higher than it has been in decades, there is no shortage of critics of the Bank of England. Still, the bulk of the blame seems largely unfounded.
The BoE has been criticised for being too slow to raise rates and doing too little since. But the central bank was dealt a particularly bad macroeconomic hand to play.
An earlier, tighter policy regime would have had only a limited effect in damping current inflation, and under the circumstances, the BoE’s monetary policy course might be the best choice among a set of difficult options.
On our forecasts, higher food and energy bills will directly account for 60 per cent of the anticipated peak inflation figure in October print. Non-core inflation is not something monetary policy can impact.
In December last year, the BoE made the point that, given the lags of monetary policy, to address a build-up in imported inflation even prior to the Russian invasion of Ukraine, it would have had to start a fairly aggressive policy tightening as far back as during the first wave of the pandemic in early 2020. That was just as the UK economy was about to be battered by an almost 20 per cent quarterly contraction due to the first lockdown.
Implementing such a tight policy may have contained inflation to the BoE’s desired goal of 2 per cent by early 2022, but unemployment would have shot up by about 800,000 jobs, according to the central bank’s modelling.
In fact, compared with its peers, the BoE’s reaction was rather timely. As early as last September, it acknowledged that inflationary pressures might not be transient; and by February, it had raised rates twice and announced the start of its balance sheet reduction. In stark contrast, the Fed and the ECB were then still purchasing assets under their QE programmes.
Even the UK’s labour market tightness is probably more a supply than a demand story. Employment is still well below its pre-Covid peak — by 210,000 jobs — with labour supply down by 290,000 workers as recently as May.
Apart from reduced migrant inflows, the lower domestic participation rate is a problem too. For example, the UK has never had as many potential workers outside the labour market due to health issues. The BoE can impact labour demand by slowing growth, but there is nothing it can do to shorten NHS waiting lists.
Moreover, the relatively lacklustre post-pandemic recovery in the UK belies the argument of monetary policy-driven inflation. Business investment growth has been very subdued, and consumption growth is now slowing too despite the simplistic read of real rates of negative 8 per cent after taking forecast inflation for August into account.
Instead, it can be argued that a Brexit-related reorientation of imports away from the EU is a possible culprit in surging prices. UK manufactured goods inflation was at its recent peak over 4 percentage points higher than in the euro area. Even the conventional view that higher rates alone can help prop up the currency, and thus damp inflation on imported goods, was undone last week when the sterling-dollar exchange rate fell following the BoE’s bold 0.50 percentage point rate rise, as traders focused on weakening growth.
Facing a more difficult employment and inflation trade-off than for other central banks, BoE action has been largely gradual in its approach in the first half of this year. Given it is forecasting a medium-term inflation rate of well below 2 per cent, there is an argument that the current pegging of Bank Rate may already have reached the level consistent with the BoE’s remit of returning inflation to 2 per cent over time.
Still, with short-term inflation expectations elevated, and another imported inflationary shock on the horizon as gas and electricity prices are scheduled to rise again in October and January, the Monetary Policy Committee opted for a more forceful approach last Thursday. Increasing rates by 0.50 percentage points while forecasting a prolonged recession demonstrates the MPC’s intent to act against any and all inflationary pressures.
So, what then of possible fiscal policy? In our view, fiscal action should be aimed at low-income households, which have seen relatively weaker wage growth thus far and probably have little to no excess savings from the pandemic. Such targeted support would shield the most vulnerable, while having a limited impact on inflation.
Easing labour supply shortages could also have the effect of lowering inflation, so supporting the NHS in a faster reduction of its waiting lists is a good option. The BoE has a difficult task and no easy policy choices. Fiscal policy should not make the Bank’s already challenging task even more complicated.
The graph in this article has been amended to include the latest rate rise from the Bank of England