Sunday, April 30, 2023
The Bank's in a mess, and badly needs inflation to plunge
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.

This is a torrid time for the Bank of England, probably the most difficult since it was granted independence 26 years ago next month. Since it began to raise interest rates in December 2021, inflation has risen from 5.4 per cent to more than 10 per cent, where it has been lodged for longer than expected. Average earnings growth, measured by regular pay, has risen from 3.6 to 6.6 per cent over the same period. The figures appear to be cocking a snook at the Bank’s efforts.

Meanwhile, Huw Pill, its chief economist, has achieved a rare feat by uniting the Tory tabloids and the trade unions with remarks in which he said that people had to accept they were worse off because of the higher energy prices resulting from the Russian invasion of Ukraine and other factors. Pill was pilloried, pun intended, by the tabloids and the unions in equal measure, with Unison, a union, describing him as “living on another planet”.

This is not the first time that the Bank’s verbal interventions have gone down like a lead balloon. Pill perhaps could be said to have been “taking one for the team”, or at least for his boss, the governor Andrew Bailey, who has usually been on the receiving end of such criticism.

Pill’s comments were well meant and economically accurate. People have been made worse off by the negative economic shocks of recent years. But, like those of Bailey, they were almost guaranteed to be misunderstood, implying that the Bank is blaming workers and businesses for high inflation. They also ran the risk of smacking of desperation.

Since the Bank started raising rates nearly 18 months ago, one of the questions I have been asked most often is: What is the point of doing so when the shock is largely an external one? A close second is: How exactly is raising rates supposed to bear down on wage growth, which is clearly one of the Bank’s big worries?

Both are very fair questions. After all, until it became converted to the idea of responding to the inflation threat late in 2021, the Bank’s view had been that the rise in inflation was “transitory”. In those days before the Ukraine war, its view was that the reopening of the world economy after the pandemic had pushed up inflation, but it was only temporary.

As for pay, I have always argued that we were not seeing a wage-price spiral and would not do so. Stronger growth in nominal pay – wages in cash terms – are a consequence not a cause of high inflation. Real wages are falling, by 2.3 per cent on a year ago for regular pay, and 3 per cent for total pay. This, according to Office for National Statistics, is one of the largest falls in real wages on record.

How do I answer those questions? The shift from “transitory” to troublesome occurred a little before the Russian invasion when it became clear that the UK was not just experiencing an external shock. Core inflation, excluding food, energy, alcohol and tobacco, rose – and is strong now at 6.2 per cent - as did service-sector inflation. Thus, some of the UK’s inflation is domestically generated and higher rates were the appropriate response to that. The question is whether they should have gone up a little earlier.

As for pay, the main driver of lower nominal pay increases will be falling inflation, but the Bank has been keen to help that process along, not just by clumsy comments, but also by reminding those negotiating wages and salaries that it can intensify the monetary squeeze. Before anybody says it, higher interest rates to not cause inflation by encouraging people to push for bigger pay rises to compensate for their higher mortgage costs. The direction of travel is the other way.

Having said all this, the beleaguered Bank badly needs things to start going its way. It is several weeks since I woke up very early to hear the morning radio programmes confidently predicting that we would see inflation drop into single figures, which the markets were looking for. But it came in at 10.4 per cent and, another release later, remains in double figures.

Pay settlements averaged 6 per cent in March, according to the consultancy XpertHR, and there is always an element of wage drift which takes actual pay rises above the settlement figure. A year earlier the average settlement was 3.7 per cent.

Will things start to go the Bank’s way? Perhaps we should look to two former members of its monetary policy committee (MPC) for guidance. In an interview with Sky last weekend Andy Haldane, the Bank’s chief economist, said a sharp fall in inflation in coming months was “pretty much nailed on” and that the government should have no trouble of achieving its ambition of halving inflation by the end of the year.

That fall, of course, overwhelmingly reflects the impact of lower energy prices. And, interestingly, he suggested, that it might be time to press the “pause button” on rate rises. Markets, it should be said, think the Bank will raise from 4.25 to 4.5 per cent on May 11.

Another interesting perspective was provided by Michael Saunders, an MPC member until last September, now a senior adviser to Oxford Economics. His central point in a new analysis is that we may have to get used to bigger interest rate swings over the next 20 years than the past 30, because of more volatile inflation. But he thinks that one more rise next month will be enough from the Bank this time, and also points to evidence that higher rates are working. The lags between interest rate changes and their impact are important.

As he puts it: “Typically, housing, which is very interest rate-sensitive, starts to weaken two-three quarters after the first interest rate hike, with aggregate economic activity weakening a quarter or two later and labour market pressures weakening after about a year.”

That, he suggests, is now happening and, importantly, those effects will persist even after the Bank has stopped raising rates. The weakness in many housing market measures suggest that monetary policy is now restrictive, he suggests, and “the conditions are now in place for prices and pay to weaken significantly in the next few quarters”.

That will be music to the ears of Threadneedle Street. The Bank will be hoping that this is indeed the case. Never has it needed the numbers to start going it way so badly.