Sunday, July 31, 2022
The Bank walks a tightrope - can it avoid falling off?
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 will not be a huge shock if the Bank of England raises interest rates on Thursday. It will, in fact, be a big surprise if they do not do so. After a long period in which you could safely write off any action from the Bank’s monetary policy committee (MPC), which was happy not to raise (or lower) rates for most of the period between the global financial crisis and the Covid-19 pandemic, rate rises have been coming thick and fast.

Thursday’s will be special for three reasons. It will be the sixth rate rise in a row, something which has never happened before. There have been plenty of occasions in the past when official rates have risen more in one fell swoop than the “little and often” changes of recent months.

In January 1985, for example, the then equivalent of Bank rate rose by 4.5 percentage points in an effort, which was successful, to stop the pound from falling to less than a dollar. But the nearest thing to what we are seeing now was in the early period of Bank independence, when the rate rose from 6 per cent in May 1997 to 7.5 per cent in June 1998. This period of tightening, which began last December, is quicker.

The second reason is that, following a broad hint earlier this month from Andrew Bailey, the governor, markets expect an increase this week of half a point, or as they would describe it, 50 basis points. Bank-watchers among economists, I should say, are split on whether it will be 25, a quarter, or 50, a half, with the majority favouring the latter. If it is 50, it will be the first time this has happened in the post-1997 independence era, though you only have to go back a couple of years before that, to early 1995, for the last time it happened.

Thirdly, this should be the week in which the MPC signals its intention to actively reverse its quantitative easing (QE). Bear with me a second on this. I am used to people’s eyes glazing over when I talk to them about QE. A short talk on the subject could usefully double up as a sleep aid.

The transition from QE to QT, quantitative tightening, is even more of a challenge, but it is quite straightforward. QE is the creation by the Bank of money, in the form of reserves, which it uses to buy assets, mainly UK government bonds, gilts. At its peak, QE amounted to £895 billion, with most (just) done since the start of the pandemic. The process of reversing this through QT has already started, through the passive route of not reinvesting the proceeds of maturing gilts, reducing the QE total to £867 billion.

Simply doing this would be a very slow process, however, It would take four or five decades to fully unwind QE in this way, which is why the Bank is about to move to active gilt sales, as well as running down the £20 billion of corporate bonds in its portfolio to zero. Bailey has signalled that combining the passive and active approaches will lead to QT of between £50 billion and £100 billion in the first year. The significance of this is that it complements rising interest rates. It is another way of tightening policy.

I have tried your patience enough. On another occasion, when I have time and space, I will deal with the old and barmy chestnut – why don’t they just cancel the government debt that the Bank has bought? But not now.

For now, let me deal in anticipation with two sets of emails that I know I will get on Thursday, when the Bank does raise rates. One set of emails will be querying vociferously why the Bank has to act at all, and risk tipping the economy into recession, when all the inflation that we are experiencing is international.
The other will be questioning whether the piddling rate rises we are seeing from the Bank can possibly do anything about an inflation rate that is already 9.4 per cent (11.8 per cent for retail price inflation) and heading higher.

I did not want to mention the Tory leadership contest but both candidates should be criticised for scaring people and potentially making a difficult situation worse, Liz Truss has talked of Rishi Sunak’s tax increases inevitably driving the economy into recession, while the former chancellor has been highlighting comments from Patrick Minford, the Truss-supporting economist, that Bank rate, currently just 1.25 per cent ahead of this week’s move, could have to rise to 7 per cent.

A recession is not inevitable. In fact, a range of indicators, including the closely watched purchasing managers’ surveys, retail sales, and the labour and housing markets, suggest that the economy is holding up better than feared. There may be a small fall in gross domestic product in the second quarter, but that would have as much to do with the extra bank holiday for the Queen’s platinum jubilee as underlying weakness.

If there is a proper recession, it will not be driven by Sunak’s tax rises, or the Bank’s interest rate hikes, but the threat from Vladimir Putin of cutting off gas supplies to Europe this winter, a threat which is already producing scary figures for the energy price cap this autumn and underlines the point made here last week that more targeted help for those hardest hit will have to be announced, not across-the board tax cuts.

As for the Bank being too timid, it was last year in persisting with QE when it should have stopped, but since it began to raise rates, it has acted quickly. The idea of a 7 per cent Bank rate being needed is for the fairies. Rates will rise further after this week, but 3 per cent, or 3.5 per cent at a stretch, is the likely endpoint.

For, while gas prices will push up headline inflation, encouraging things are happening below the surface. I can bore about petrol prices almost as much as about QE but in recent days I have seen independent garages dramatically undercutting the supermarkets and selling for as little as 168p a litre, prices not seen since the spring. Oil prices have settled well below levels in the immediate aftermath of the Russian invasion.

It is not just petrol. “Core” inflation, excluding mainly food and energy, looks to have peaked at 6.2 per cent in April and was down to 5.8 per cent in June. Inflation in clothing and footwear has decelerated, as have some other components of the consumer prices index. Inflation is still too high, and will go higher, but there is evidence that policy is starting to work on those parts it can influence. Sterling has also staged a small recovery after the dethroning of Boris Johnson, which will help.

The Bank is treading a tricky tightrope, and it will not keep everybody happy. Its target is a softish landing for the economy, scraping close to but just avoiding recession, though its forecasts this week will be downbeat, and a big fall in inflation, starting next year. It may fall off the tightrope, which is always a risk, but it is right to give it a try.