The Bank of England’s Monetary Policy Committee (MPC) has raised interest rates by just a quarter point, to 1.25 per cent. This was the fifth increase in as many meetings, but still leaves rates near historic lows. In my view, this was a mistake.
This decision is hard to square with April’s consumer price inflation figure of 9 per cent, or the Bank’s own expectations that the CPI measure will now top 11 per cent in October. Nonetheless, the MPC judged (by a majority of 6 to 3) that not enough had happened since it last met in May to justify a different pace of tightening.
To be fair, there were no ‘game changers’ in the latest economic data. The April GDP figures were a little weaker than expected and there are still few signs of the wage-price spiral that some fear. Against this, other indicators suggest that private sector activity is holding up well and that the labour market remains tight. With uncertainty so high, perhaps ‘steady as she goes’ was the safest call.
However, this assumes that the original plan was the right one in the first place. The reality is that the MPC, like many others, has consistently under-estimated the strength and persistence of inflation. Even this month, Bank staff have had to revise up their forecast for the October peak – yet again.
It seems clear that the earlier analysis was badly wrong and that a new approach is now needed. Here, the Bank of England’s continued ‘gradualism’ contrasts with the changing stance of the Fed, which raised US interest rates on Wednesday by a full three-quarters of a point.
The US economy is currently stronger, but falling even further behind the Fed risks adding to concerns over the MPC’s credibility.
This could add to inflation by undermining the pound. However, recent hype about a ‘sterling crisis’ means that the currency markets may already have priced this in. The pound actually rallied following Thursday’s announcement (after an initial wobble), partly because the Bank’s statement left open the possibility of shifting to larger moves later in the year.
The bigger threat may lie further ahead. If the Bank of England needs to play catch up, it may eventually have to raise interest rates more aggressively than if it were bolder now. In other words, it is better to return rates to more normal and sustainable levels quickly, rather than delay the inevitable.
This appears to be the Fed’s thinking – and it is not alone. The Reserve Bank of New Zealand (RBNZ), which pioneered inflation targeting, raised its key interest rate by half a point in May, to 2 per cent.
The RBNZ applies the sensible test of ‘least regrets’, weighing the risks of tightening policy ‘too little, too late’ against those of doing ‘too much, too soon’. Its judgement was that the greater risk was moving too slowly and not far enough.
On the same basis, I would have voted for at least a half-point increase in the UK this week, mainly because of the signal that this would have sent. At these exceptionally low levels, and with inflation so high, it does not really matter for the economy whether nominal interest rates are 1 per cent or 1.5 per cent. But a bigger increase might at least have helped to rebuild some credibility.
As it is, yet another quarter point hike is unlikely to please many people. Indeed, some will wonder why the MPC has raised rates at all. Many are already arguing that inflation mainly reflects supply-side problems and that premature tightening of monetary policy could simply tip the economy into a recession.
Danny Blanchflower, a former MPC member and leading ‘dove’, has gone further and claimed that a recession would be worse than inflation. His view is that a one percentage point increase in the unemployment rate could do five times as much harm to people’s wellbeing as a one percentage point increase in inflation.
These points are not new. The MPC’s remit already recognises that inflation may sometimes be knocked off course by external shocks, and that the short-term costs of trying to bring inflation down quickly may outweigh any longer-term benefits. But with inflation so far above the 2 per cent target, the MPC has surely already used up all this wiggle room.
It would also be wrong to assume that there is a simple and unchanging trade-off between inflation and unemployment. If inflation is allowed to remain high, a recession actually becomes more likely, and unemployment may surge anyway.
The usual rules of thumb may not apply either when the labour market is as tight as it is now, and when inflation is so high. In these circumstances, the costs of inflation are greater than usual, especially for households on low incomes, and there is a lower risk of losing your job (or failing to find another).
Above all, it is wrong to assume that interest rate hikes only work by slowing the real economy, or by increasing unemployment. It should be enough to slow the growth of nominal demand, so that less money is chasing the same amount of goods and services. Basic monetary economics says that supply-side problems only determine relative prices, not the overall rate of inflation.
None of this would require the Bank to slam on the brakes. Just a signal may be enough. A bolder move would have demonstrated that the MPC is willing to do ‘whatever it takes’ to bring inflation back under control. This would reduce expectations for inflation and, since these expectations influence pricing decisions now, this should have had immediate benefits.
Instead, a drip, drip of quarter-point increases, when interest rates are so low to begin with, is unlikely to have any significant impact. The Bank should either have gone big, or not bothered.
This piece was first published by the Daily Telegraph on 17th June 2022