Sunday, June 27, 2021
As inflation jumps, the Bank risks falling behind the curve
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

It may not have been obvious to everybody but the decision of the Bank of England’s monetary policy committee (MPC) on Thursday lunchtime was actually quite a bold one. When I say decision, I should say non-decision. The committee stuck with its previous policy.

Why bold? Nobody expected the risk-averse MPC to contemplate an increase in official interest rates from the current all-time low of a mere 0.1 per cent, though some would have liked to have seen it, or at least a signal that it could happen before long.

No, the boldness was to persist with the latest tranche of quantitative easing. This, agreed last November, was for an additional £150 billion of asset purchases, mainly UK government bonds, to be completed by the end of this year, taking the total up to a huge £895 billion.

Early last week I chaired an online seminar, a webinar, organised by the Spinoza Foundation, featuring two former members of the MPC, neither of whom would be regarded as particularly hawkish. They were agreed, however, that in the context of a strong recovery and rising inflation, the QE agreed last November should be immediately halted. There is still £72 billion of the £150 billion agreed last November yet to go, according to the Bank, so in their view that should not happen.

A similar view was expressed by The Times shadow MPC, all nine members of which voted to call a halt to QE. This view did not go entirely unheard on the actual MPC, with the Bank’s departing chief economist Andy Haldane, voting for a second month in succession – at his final meeting – to cut the QE total by £50 billion. If the other members gave him a leaving present, which I am sure they did, it was not this. The other eight voted to stick with the programme.

This, to me, while not at all unexpected, was nevertheless a bit of a puzzle. Stopping some of the QE, if not immediately then very soon, would have been an easy way for the Bank to show that it was concerned about the rise in inflation now coming through. Growth in the economy has been coming through more strongly and inflation is higher than the Bank expected. In the dark days of November, during the second lockdown, when this QE decision was taken, nobody had even yet received a Covid vaccination. When the facts change, as the saying goes, you can change your mind, and without any loss of face.

By sticking to its dovish guns, the MPC majority runs two risks. The first is to fall “behind the curve” as inflation comes through. Monetary policy is supposed to be flexible, but sticking with a QE programme that will run for more than a year is inflexible and displays a lack of concern over an inflation rate that it now expects to rise above 3 per cent later this year.

The second danger, which Bank insiders always play down but many outsiders regard as a serious issue, is whether the Bank, in persisting with QE even as the economic arguments for doing so weaken, is helping the government out a little too much with its purchases of gilts (UK government bonds). It rejects the charge of what is known as monetary financing but others are not so sure.

When does inflation become a problem? As I have written here before, there are plenty of reasons to think that some of the current upturn is temporary, or “transitory” as central bankers like the Bank to say. It will, in other words, fade. Base effects – comparisons with very weak levels a year ago – are driving some of the current increase. The MPC majority, it should be said, is betting heavily on this being the outcome and that inflation will soon return to 2 per cent.

The Bank also takes comfort from the fact that inflation expectations are, in the jargon, “well anchored”. Its latest survey of public views on inflation, carried out by TNS, and released earlier this month, showed that while people had a median expectation for inflation of 2.9 per cent in the coming year, this came down to 1.9 per cent in the year after that.

In five years, people think inflation will be 2.6 per cent. That is above the official 2 per cent target but, significantly, below the 3.4 per cent five-year view that the public had in February. Most of the survey results, carried out in May, were below those in February. It remains to be seen whether those views stay the same when people are asked again after the rise in inflation over the summer and autumn.

People sometimes ask why it is important to keep inflation low – which the Bank’s survey shows the public supports – and whether there is anything magical about a 2 per cent target. Indeed, a debate has been raging since the global financial crisis more than a decade ago about whether central banks should target a higher inflation rate, say 4 per cent.

The traditional argument for inflation targeting, and indeed for choosing a target of about 2 per cent, is that at such a level it does not distort economic decisions. When inflation is higher, people and businesses start taking action to avoid it. That distorts economic behaviour and can damage economic growth.

We have not reached anything like that point yet, with inflation only a smidgeon above the official 2 per cent target, though I know from my mailbag that many people think it its higher, but inflation worries may already be starting to affect behaviour.

The latest consumer confidence index, published by GfK and released on Friday, showed that confidence stalled at minus 9 this month, breaking its rising trend. Some of that may have reflected uncertainty about the coronavirus and the Delta variant but GfK also uncovered worries about rising inflation. Forecasts of rising inflation, if realised, could dampen confidence further, it warned.

Bank of America, in its “consumer whisperer” report, noted that after rocketing between March and May, consumer confidence on its measure had slipped over the past fortnight, not because of the delayed removal of restrictions but, rather, because higher inflation is starting to squeeze real incomes.

For businesses, the reality of rising costs, and the necessity of passing them on in higher prices, is even more pressing. According to the latest “flas” purchasing managers’ index from IHS Markit: "The rate of input cost inflation accelerated for the fifth month running and was the joint-fastest on record, equal with that seen in June 2008. While inflation continued to be led by the manufacturing sector, service providers also posted a marked increase in input prices. In turn, the rate of output price inflation hit a fresh record high for the second month running.”

This is something to be watched. The Bank may be relaxed. Many are not.