Sunday, July 24, 2016
Bank will fight the economic downturn, not the upturn in inflation
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

2015 was an unusual year, though not as extraordinary as 2016 is turning out to be. Last year was strange because for the first time in more than half a century there was no inflation at all. Inflation, which in one way or another has dogged most of our lives, disappeared.

Indeed, there were three months last year when Britain experienced technical deflation; consumer prices lower than a year earlier. Before anybody writes in, not all inflation disappeared; there was still plenty of it in the housing market. But the overall price level stabilised.

That brought direct benefits to households. Even modestly rising average earnings of 2% to 3% looked good when set against zero inflation, delivering solid gains in real incomes and boosting consumer confidence.

Inflation remains very low now. The latest figures, for June, showed a rate of just 0.5%, up from 0.3% in May. We have, however, said farewell to the days of zero inflation, and of flirting with deflation. From here, the direction is up.

Some of this was going to happen anyway, as a result of the recovery in oil and commodity prices, and their earlier falls dropping out of the year-on-year comparisons. It has been given an additional boost, of course, by the pound’s post-referendum fall.

The extent of that inflation boost is a matter of some debate. The consensus in the new independent forecasts assembled by the Treasury since June 23 is that the economy will experience mild stagflation next year, with growth of just 0.5% and inflation by year-end of 2.5%.

Mild, however, is the operative word. After all, 2.5% inflation is only a smidgeon above the official 2% target. Some forecasters, it should be said, see a much bigger pass-through from the lower pound, and predict 4% inflation next year, but that is not the majority view.

Even so, the coming rise in inflation has two important implications. One is that, unless there is an accompanying increase in the pace of pay rises, there will be a return to at best stagnant growth in household real incomes, at worst falling living standards. In the latest official figures, for May, total pay was only up by 2.1% on a year earlier. A squeeze on real incomes will have implications for consumer spending and consumer confidence.

The second, which is as interesting, is what it implies for monetary policy and, in particular, interest rates. Not for the first time in recent weeks I have felt a lot of sympathy for Mark Carney. In contrast to the dithering and confusion that marked the response to the onset of the global financial crisis nine years ago, his has been a textbook central banker reaction.

He offered reassurance – and a promise of £250bn of additional liquidity – in the early morning of June 24. Six days later, in a speech at the Bank, he pledged that the Bank would do its utmost to “support growth, jobs and wages” during this time of uncertainty.

Carney was not the only one to offer reassurance. So, once he got over the shock of the referendum result, did George Osborne, the former chancellor. The rapid coronation of Theresa May as prime minister, also helped to settle nerves.

One response to Carney’s success in helping to calm market nerves, which is that he was wrong to warn of the economic dangers, can be easily dismissed. He has done exactly what everybody is supposed to do: accept the result, deal with the consequences, and move on.

What is also clear, however, that the calming of nerves has revived a debate within the Bank of England. In May, when the Bank published its last inflation report, it talked of a “challenging trade-off” between the inflation and growth impacts of a vote to leave the EU. Should the Bank, in other words, respond to the threat of high inflation or the risks of a prolonged period of weak growth?

We know now that different members of the monetary policy committee (MPC) have different views on this. One, Jan Vlieghe, had already seen enough by July 14 to vote for a rate cut. Carney, in his June 30 speech, said “some monetary policy easing will likely be required over the summer”.

Andy Haldane, the Bank’s chief economist, said just over a week ago that he would “rather run the risk of taking a sledgehammer to crack a nut” and said “a package of mutually-complementary monetary policy easing measures is likely to be necessary”.

But not everybody agrees. Martin Weale, whose final MPC meeting will be next month, struck a cautious note, saying he would need to be sure that weakness in the economy will be large enough to “more than to compensate for any overshoot in inflation”.

Kristin Forbes, another MPC member, wrote in the Daily Telegraph that until there was more hard evidence, her instincts were to “keep calm and carry on”. She also pointed out that there are costs as well as benefits to cutting rates, and not just for savers.

So what does all this mean? Will the Bank cut on August 4, or not? One thing the current debate has done is kill the idea that the Bank is Carney’s fiefdom, and that the rest of the MPC is just there to carry out his instructions. That was said a lot, including by former Bank insiders, in the run-up to the July 14 meeting at which the MPC surprised the markets by holding rates. We should hear less of it now.

I still think, however, that there will be a cut on August 4, probably of 0.25 points, along with other measures, including more quantitative easing and a rebooting of the funding for lending scheme. The justification will come from a sharp downgrading of the Bank’s growth forecast and the argument that it is right to “look through” the temporary effects on inflation of the pound’s fall.

Will it be the right thing to do? Until Friday, and the release of an alarming new purchasing managers' survey, there was a debate to be had. The Bank's own agents had found little evidence of a sharp post-referendum slowdown. The composite purchasing managers' index plunged from 52.4 to 47.7, however, with its services component recording its sharpest reversal in its 21-year history. How long this very deep gloom lasts can be debated. For the moment, however, the MPC has little choice but to respond aggressively.