The challenges facing the Bank of England
1 August 2022
This Thursday will see the Bank of England raise its headline interest rate for the sixth time in a row. Having increased interest rates by 0.1% and 0.25% increments so far, the Bank’s decisionmakers are actively considering a 0.50% increase as they grapple with UK inflation that is set to top 12% by January. The impact of this decision is highly significant to both savers and borrowers. Not because these are big moves. Whatever happens on Thursday, UK interest rates will remain below 2%. This is still lower than their level in sixty-four out of the seventy-seven years since the end of the Second World War. The significance is that the other thirteen years have also been the last thirteen years.
Make no mistake, the Bank of England is not where it wants to be. Derided in some quarters for being too slow to act to stem inflation. Criticised in other quarters for now raising borrowing costs as economic momentum slows. In the twenty-five years of independence from direct government control this is the Bank’s toughest monetary policy assignment.
Opinion columns in national newspapers are full of commentary on how the author would have done things differently. Some of these columns even suggest ideas they claim could have avoided the inflation mess now bestowed on the UK economy. However, the reality is that even those who warned about rapid money supply growth during 2021 and over-stimulus of the economy could have done relatively little to avoid the current inflation surge. If that is an acknowledgement of domestic policy impotency, so be it. The UK economy is around 3% of total world economy. Many of our economic conditions, including inflation, are determined by decisions in Beijing, Berlin, and Washington rather than London.
There have also been utterances from some Conservative MPs citing how much lower inflation has been in countries such as Japan and Switzerland. They have tried to link this to domestic monetary policy decisions. This suggests, alas, that they know more about generating headlines than about economics. It is worth repeating, almost ad nauseum, that this is a global inflation phenomenon with a few obscure outliers. Any domestic missteps on issues such as Brexit, UK interest rates and the pandemic response have been marginal contributors to rising prices. The biggest influence on current UK inflation still sits, unbowed, in Moscow.
So, what can be done by the Bank of England this week? The first is to share their updated thinking on the UK economy in their quarterly Monetary Policy Report. There can be little sugar-coating of the message. With household energy costs set to absorb an average of 15% of disposable income by January – up from 4% in 2021 – this is a hugely negative impact on consumer spending power. Energy costs are also approaching the level where energy-intensive businesses will be pulling back the hours they operate. This means production lines shutting down early and hospitality businesses limiting their opening hours. What remains a strong jobs market will be put to the test over the winter by these conditions. These headwinds to economic growth look set to push the UK economy into recession by the end of the year.
The second challenge for Bank of England policymakers is to unveil plans to actively sell off the Bank’s holdings of UK government debt. Since 2009 the Bank of England has built up a stock of Government Gilts worth around £850 billion. This was undertaken to help keep interest rates low to support the UK economy as it recovered from the Global Financial Crisis, dealt with the fallout from the Brexit vote and then, most recently, the COVID-19 pandemic. This debt buying is known as Quantitative Easing. We will now hear more about the equally catchy title, Quantitative Tightening, as the bank sells this debt. With inflation approaching double-digits there is little justification for continuing to own government debt on this scale. However, should the Bank’s sales push up the interest rates faced by the government the Monetary Policy Committee are going to win few friends in Westminster.
The third aim will be to remind the British public the advantages we all get from low and stable prices. In recent decades high inflation, as well as the disruption and hardship this creates, has been infrequent. Brought back into sharp relief by the post-pandemic recovery, the tough decisions required to avoid inflation becoming embedded need to be shared with the public. These efforts have, so far, been rather cumbersome. The Bank’s governor, Andrew Bailey, made an ill-advised venture into discussing whether workers should ask for pay increases. Good communications are all about the message, not the messenger. In this regard, central bankers are like sports match officials: they are doing a good job when you don’t notice them.
The fourth and final task is to dispense with forward guidance. Forward guidance is when central banks communicate a future policy path for interest rates. A range of central banks including the US Federal Reserve and European Central Bank have recently managed to tie themselves in rhetorical knots by doing this. They have both now ditched explicit forward guidance. Given the scale of uncertainty ahead there is little point the Bank of England, voluntarily, providing forward guidance that will likely end up undermining its own credibility.
These four challenges for the Bank of England all come against the backdrop of the race to be the new UK Prime Minister. The plans of Rishi Sunak and Liz Truss will inevitably lead to a different type of economy and inflationary backdrop. Sunak represents something of the status quo, whilst Truss has tax and spending plans that will, all else being equal, require modestly higher interest rates. I would expect the Bank of England to be invited to pass comment on the inflation effect of both candidates’ tax and spending plans. The Bank of England may be politically independent, but it is not independent of politics. The next few months will see this relationship tested like few other periods in its history.
Managing Director, Chief Economist