Sunday, February 06, 2022
Rampant inflation lets the Bank's hawks take flight
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. Not to be reproduced without permission

Super Thursday has many meanings. It is used to describe those occasions when several important elections take place simultaneously, or when people like me try to analyse a bunch of official statistics published at the same time on that day, some of which get missed in the rush. In the publishing industry there is a Super Thursday each autumn, when more new books are published than on any other day of the year.

We had a different sort of Super Thursday last week, though most people would say there was nothing very super about it, and that Black would be a more appropriate description. First off was the announcement of a huge 54 per cent increase in the energy price cap to within a whisker of £2,000 a year - £1,971 – by Ofgem, the energy regulator.

Then came Rishi Sunak’s measures to ease the energy burden, yet another significant fiscal announcement made separately from a budget or other formal occasion, as has been the pattern during the pandemic.

Finally, the Bank of England stepped up, raising the official interest rate to 0.5 per cent, as had been widely expected, but also revealing more hawkishness than anticipated. This was both in the fact that four of the nine members of its monetary policy committee (MPC) voted for a bigger increase in rates, to 0.75 per cent.

Not only that, but as I suggested last month it would, the Bank has shifted from quantitative easing (QE) to quantitative tightening (QT). The massive QE it has undertaken since the depths of the financial crisis, will be gradually reversed. Again, this went a little further than expected.

There are two elements to QE. Most, £875 billion of the £895 billion total, is in UK government bonds, gilts. The Bank’s decision not to reinvest the proceeds of these gilts when they mature, which it has been doing up to now, will reduce QE by nearly £28 billion next month, by a total of £70 billion over 2022 and 2023 combined, and by a further £130 billion during 2024 and 2025.

That would still leave the stock of gilts held by the Bank at £675 billion at the end of 2025, though the Bank could go further to reduce it by actively selling gilts back to the markets. It could begin to do that, on its own rule, when Bank rate reaches 1 per cent. Markets have in mind a 1.5 per cent rate, later this year or next. Whether it does so or not, Thursday’s decision gives the lie to the very many people who have told me over the years that QE would never be reversed. This is even more the case with the £20 billion corporate bond element of QE, which will be fully unwound by the end of 2023 through a combination of not reinvesting maturing bonds and active sales.

What do the first back-to-back interest rate increases for 17 years, QT, and the chancellor’s response to high energy bills tell us? Does raising interest rates make a bad situation worse, as some would say?

Thursday’s flurry of monetary and fiscal announcements tells us, first and foremost, that policymakers have been badly caught out by the surge in inflation. There was an element of panic in these moves. As I discussed last week, most economic forecasters were caught out by the inflation surge.

The particular problem for the Bank, as its governor Andrew Bailey discussed in the press conference after the rate hike, was that, given the lags between changes in monetary policy and its impact, it would have been necessary to raise rates before there was any sign of the danger and in the middle of the pandemic, at a time when the chancellor, through fiscal policy, was providing extensive support. There is never a good time to raise rates, but that would plainly have been a bad time.

As for the chancellor, giving with one hand while taking away with another is not a good look, and reflects the danger of pre-announcing tax hikes. He was right to resist calls for abandon the National Insurance hike, as I argued last week. Some of those pre-announced tax hikes, most notably the potentially painful freezing of income tax allowances and thresholds in April, date back to the budget in early March last year, when it was reasonable not to foresee the extent of this spring’s inflation.

But in September, when the NI increase was announced, it was already clear that inflation was soaring, as were energy prices. I suspect that the Treasury was focused on getting the NI hike agreed, as it was last Sunday in this newspaper, ensuring that Downing Street was fully on board for the increase with a joint piece confirming it from the chancellor and prime minister.

The chancellor’s moves – a £150 council tax reduction on most properties and a £200 reduction in energy bills in October, paid back in five £40 instalments in future years – aim to soften for the majority about half of the £693 increase in the energy price gap. They will leave in place most of a two-year drop in real incomes, which the Bank says is the biggest for decades.

These are not the sunlit uplands people might have expected, if not after Brexit, then after the pandemic. They are also indicative of the start of a tougher time for the chancellor, assuming he stays where he is. The debt interest bill is rising, with both bond yields and official interest rates set to rise further and, despite last week’s announcements, the Santa of the pandemic has been replaced by the Scrooge of the recovery, as he seeks to repair the public finances.

Could the Bank have made life easier for people by not raising interest rates? This is the oldest question in the book, though given the rarity of rate rise in recent years, it has lain dormant for a while. I used to get asked all the time why the Bank, or in pre-independence days the chancellor, was adding to inflation by raising interest rates. Those were also mainly the days when the standard measure of inflation, the retail prices index, included mortgage interest payments.

The answer is that higher rates reduce inflation, and this was well put the other day by Catherine Mann, a newish member of the MPC. As she put it: “I know that here has been a lot of talk already about the cost-of-living squeeze. And to be clear, it is not my goal to make this worse than it already is – to the contrary, I aim to bring inflation back down to target such that workers can enjoy real wage gains from their labour.”

An interesting real-life experiment is under way. The European Central Bank is much more reluctant to raise rates, leaving it later, though it admits the inflation risks are tilted to the upside. It would have been hard for the Bank to do that, given its forecast of 7.25 per cent inflation in the spring. We will see which approach works best.