Monday, September 26, 2022

BoE in line of fire over UK’s double-digit inflation


With UK inflation hitting double digits, the most in over 40 years and the highest in the G7 group of large economies, the Bank of England is in the line of fire from politicians and economists.

The UK’s central bank was granted independence 25 years ago with the brief of maintaining inflation at 2 per cent. But now there are questions around whether the officials in Threadneedle Street have lost control.

The team surrounding Conservative leadership hopeful Liz Truss is pointing the finger of blame at Andrew Bailey, the BoE governor, and his monetary policy colleagues. In the words of Kwasi Kwarteng, favourite to be the next chancellor: “If your target for inflation is 2 per cent and you’re predicting 13.3 per cent, something’s gone wrong.”

Suella Braverman, attorney-general and a key Truss ally, went further, telling Sky News earlier this month that in a coming review of the BoE, Truss would look at whether it was “fit for purpose in terms of its entire exclusionary independence over interest rates”.

The main case against the BoE is that it was asleep at the wheel as the economy emerged from the coronavirus crisis. This allowed spending to rise too quickly as officials failed to spot impediments to growth left by the pandemic. The result was excess demand and inflation.

Every quarter since May 2021, the BoE has been surprised by the strength and persistence of high inflation, this month raising its estimate of peak inflation from 2.5 per cent to 13.3 per cent. Double-digit inflation is expected to last for a year, well in excess of inflation forecasts for other similar economies.

Bar chart of Annual CPI inflation, July (%) showing The UK has the highest inflation rate in the G7

Andrew Sentance, an outspoken former member of the BoE’s Monetary Policy Committee, said the central bank had “acclimatised” people to extremely low interest rates. This, he said, was compounded after the pandemic by the BoE being “so slow in noticing some of the supply side and inflation problems that were building up”.

Sentance is sometimes dismissed inside the bank as a hawk who has always wanted tighter monetary policy, but his views are shared by other former officials who do not want to publicly criticise the BoE.

One former senior official and MPC member was amazed that the committee had continued with its quantitative easing programme and had printed money and bought assets throughout 2021, even though the recovery was much stronger than it had expected.

Jagjit Chadha, director of the National Institute of Economic and Social Research, said the BoE ought to have moved quicker. “They seemed reluctant to say [interest rates] needed to be normalised from such an extraordinarily low level,” he said.

His point was echoed in the regular meetings of a shadow MPC run by the rightwing think-tank the Institute of Economic Affairs. A majority of its members called for QE to be stopped in April 2021 and for interest rates to rise in July last year, half a year before the BoE acted.

Line chart of UK CPI inflation (%), with BoE forecasts showing The BoE has systematically underestimated inflation

But Bailey dismisses these criticisms. There is growing irritation inside the BoE that it is taking the blame for what it sees as largely a global problem beyond its control.

“I don’t know anybody who reasonably can say they could have forecast a Ukrainian war a year ago,” the governor complained in the press conference after the BoE told the public earlier this month that a recession was necessary to bring down inflation.

The war, along with impediments to global supply chains after Covid-19, were all beyond the BoE’s control, he added, and blamed these factors for both the UK’s high inflation and its difficult economic outlook.

Bailey likes to note that the BoE was among the first of the leading central banks to tighten monetary policy when it first raised interest rates in December last year.

MPC members are keen also to highlight what they see as the benefits of an independent central bank controlling inflation.

Jonathan Haskel, an external member of the interest rate setting committee, took to Twitter with a chart showing that despite the current problems, average UK inflation over the past 25 years had almost exactly hit the BoE’s 2 per cent target on average — and this performance was better than any previous quarter century stretching back for 800 years.

The best UK inflation performance in the last 800 years has been the period of BoE independence – UK inflation since 1221 (Points indicate averages for 25-year periods between 1221 and 2022)

There were periods when inflation was lower and also when it was close to 2 per cent, notwithstanding the difficulties of measurement, but there was no period when it was as close to the target with as much stability as the period since 1997, when the bank was granted independence.

Haskel’s chart was a modified version of one used by professor Ricardo Reis of the London School of Economics to show the benefits of central bank independence and inflation targeting.

But Haskel did not mention that Reis’s latest academic paper, which includes the chart, sets out the errors he thinks all central banks have made since the start of the pandemic, exacerbating inflation.

For now, according to Reis, the challenge is to bring down inflation. As it is very high, reducing it will involve nasty medicine. This includes “accepting lower levels of real activity”, “acting vigorously and sharply in the near future with raising interest rates” and “restating as loudly and convincingly as possible the primacy of price stability as the goal that guides policy”.

Once inflation is much too high, it is costly to bring down, regardless of who was to blame.

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