The Bank of England may finally be ready to take the foot off the accelerator – at last. The latest economic data already seem to have persuaded some members of the Monetary Policy Committee (MPC) that the time to scale back the emergency stimulus is fast approaching. I think this should start at the August meeting, though of course there is a big difference between what I think the MPC should do, and what I think they will do!
Let’s go back to basics. The central bank now seems to be expected to do everything, including tackle climate change, reduce inequality, boost productivity, finance infrastructure spending, and ensure that England win the next World Cup (OK, I made one of those up). In reality, the MPC’s main job is to manage inflation, and that should trump anything else.
The remit of the MPC is clear. The primary objective, set by the Chancellor, is to hit an inflation target of 2pc, as measured by the 12 month increase in the Consumer Prices Index (CPI). This target is symmetrical, meaning that inflation of 3pc is just as bad as inflation of 1pc.
Most importantly, the target of 2pc applies at all times. It is not, as some might prefer, a medium-term target, or a multi-year average, or a range. It is 2pc now, as well as in the future.
Of course, there is some flexibility built into the remit. Nobody seriously expects the MPC to hit the 2pc target every single month. Nonetheless, this flexibility is limited. Temporary shocks and deviations can be tolerated, but only if the economic costs of bringing inflation back to target quickly would be too great to justify the benefits. Much of the art of good monetary policy-making therefore involves judgements about this trade off and the risks around it.
CPI inflation has already jumped to 2.5% in June and will almost certainly rise further in the coming months, perhaps to 4pc. The question then is whether policy should be adjusted sooner rather than later to limit both the near-term upside and the risk that higher inflation becomes entrenched in the economy.
Many sensible people argue that the pick-up in inflation is due to “transitory” factors, including a rebound in global energy prices, ‘base effects’ from the comparison with the data in the depths of the Covid recession a year earlier, and temporary supply shortages as global demand rebounds.
Provided inflation is still likely to fall back to 2pc next year, the MPC might then be justified in looking through a brief period where inflation is above target, as it has before. In support of this, longer-term expectations of inflation (derived from survey measures and pricing in financial markets) are still fairly low.
However, I’m not convinced by these arguments. The appeal to “transitory” factors cannot be a “get out of jail free” card for central bankers. Many of these temporary pressures are already proving to be both much stronger and more persistent than expected.
What’s more, even if the rate of inflation falls back later, the level of prices will be permanently higher. It is not good enough to hope that inflation will return to 2pc in two years if it hits 5pc first. In these circumstances, inflation expectations are unlikely to remain low either, and by the time the MPC responds, it may be too late.
There is also a danger that, by focusing on individual price changes, commentators may be missing the bigger picture. Put another way, if you can find an excuse to strip out the prices of everything that is going up, “underlying” inflation will always appear to be low.
Stepping back a bit, it is not necessary to be a diehard monetarist to believe that inflation is a result of too much money chasing too few goods or services. Supply problems may determine where these prices pressures happen to show up, but they are not necessarily the root cause.
Even non-monetarists should be concerned too that there has been no mention of the surge in “monetary growth”, or the “money supply”, in any of the MPC’s recent policy statements. In contrast, the word “transitory” appeared eight times in the latest minutes.
Above all, policy needs to be flexible and to take account of the changing balance of risks. The starting point is important too. Things might be different if policy were in neutral, but the MPC is still planning to continue adding more stimulus by completing the £150bn of purchases of government bonds (“gilts”) announced last year under the policy of quantitative easing.
There is nothing fundamentally wrong with QE. Money printing is a standard tool used by central banks when official interest rates have already been cut as far as they can. Here at least I’m a bit more relaxed than the Economic Affairs Committee of the House of Lords, which has suggested that QE is a ‘dangerous addiction’.
Nonetheless, the simple fact is that the economic recovery and the pick-up in inflation have both been stronger than the MPC expected when it made the decision to expand QE last year. When the circumstances change, so should policy.
I’m not impressed either by the argument that the economy is now slowing. The evidence on this is mixed. But if the recovery is indeed running out of steam because of supply constraints, or renewed worries about Covid, injecting more stimulus would be even less wise. (If the problem is mainly on the supply side, additional stimulus would simply add to inflation pressures, while if demand is being held back by health concerns, monetary policy cannot help.)
I would therefore vote to end QE next month, or at the very least to scale back the gilt purchases that have yet to be made.
This would not derail the economic recovery; the MPC would only be reducing the additional stimulus, rather than slamming on the brakes. If anything, by keeping inflation and inflation expectations under control, an early move could help deliver a more sustainable recovery.
For these reasons, I would actually go a little further and raise interest rates too. A small increase in the Bank of England’s official rate, from 0.1pc to 0.25pc, would still leave it well below the recent peak of 0.75pc in 2019, before the pandemic struck. Real interest rates (after allowing for the increase in inflation) would also still be firmly negative.
Frankly, if a mere 0.15 percentage point increase in interest rates would be enough to tip the economy over the edge, we are all doomed. But as more are now recognising, a stitch in time could save nine.
This is an extended version of an article was first published in the Daily Telegraph on 19th July 2021