Sunday, September 24, 2023
Pay is the key to turning this pause into a peak
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.

There was a time when a Bank of England decision not to raise interest rates was so commonplace that it barely merited a mention. In one long sequence between 2009 and 2016, there was not a change in rates. Thursday’s decision by the Bank to leave rates on hold at 5.25 per cent was not, though, commonplace. After 14 successive rate rises it was big news and the fact that it was on a 5-4 vote added to the intrigue.

Having argued here last Sunday for a pause in rate rises, I was naturally delighted. It was the right thing to do. I also think we have now seen the peak in rates, though with one caveat, so do read on.

The case for a pause I set out last week did not rely on last Wednesday’s unexpectedly good inflation figures. I say unexpectedly good because the Bank of England and the Treasury had expected a small rise in inflation from the previous month’s 6.8 per cent rate. We even had an on the record quote from a Treasury minister to that effect.

You will know, however, that the news was better than that, and that inflation, instead of rising, slipped to 6.7 per cent. Even better was the news on “core” inflation, which is more important for the Bank. This measure, excluding food, energy, alcohol and tobacco – which some say leaves out all the important things – fell even more sharply, from 6.9 to 6.2 per cent. Some of this was an unwinding of upwardly distorted figures in the previous month’s data, but it was good news nonetheless.

Some people will only be reassured when we have positive real official interest rates again – actual rates above inflation – which has not been the case on a sustainable basis for the past decade and a half. But it is on its way and by the end of the year, and even more so into next year, Bank rate should be above inflation, and in time one would hope quite comfortably.

The case for a pause this time, as I say, did not assume the inflation figures would be better than expected but instead rested on clear evidence of stagnant growth, from the gross domestic product (GDP) figures and weak purchasing managers’ surveys, together with strong evidences of a turn in the labour market, with unemployment rising and employment and vacancies falling. The Bank could have ignored all this and raised rates because of its worries about the strength of pay growth. But there were distortions in those figures too.

Now that the sequence has been broken, how will we look back on this period of frenetic monetary tightening by the Bank and other central banks as it reaches its end point? It has taken us into territory that we thought was consigned to economic history, with policymakers battling against the highest inflation in decades. In the Bank’s case that meant 10 and 11 per cent inflation in eight months over the past year or so, against an official target of 2 per cent. Inflation on the old target measure (the retail prices index excluding mortgage interest payments – RPIX) reached a peak of 13.9 per cent in October of last year.

Small wonder, then, that the Bank’s actions since December 2021 have smacked of panic, not least because the UK looked to be in danger of becoming an inflation outlier compared with other countries, a dangerous echo of the way things used to be. The sick man of Europe story, when applied to the UK, was as much about the economy being more inflation prone than others as it was about terrible industrial relations. Both have made a reappearance recently, though not to the same extent as before.

In that panic, the Bank’s monetary policy committee (MPC) tore up some of the rulebook it had used since independence in 1997. That rulebook implied that, with the committee carefully weighing up the evidence regularly, small touches on the tiller would be all that was required.

Sure enough, from May 1997 until August last year, Bank rate never went up by more than a quarter of a percentage point, 25 basis points in market parlance, at a time. August 2022 saw a half-point hike and there were four more to come in the sequence, along with one of three-quarters, 75 basis points, in November last year.

The Bank got behind the curve and had to make up lost ground at a sprint.
For those looking forward to rate cuts, by the way, and we have been told not to expect those for quite a while – the favoured image is of Table Mountain rather than the Matterhorn -, there have been plenty of cuts since 1997 which have been bigger than a quarter when the occasion has demanded it. They have included several halves and a full percentage point in late 2008 during the global financial crisis.

Why did the Bank need to panic? There are those, including the former governor Lord (Mervyn) King, who blame the MPC for ignoring the inflationary effects of its own monetary expansion - £450 billion of quantitative easing (QE) – in response to the pandemic.

There is some clearly some truth in that, and I have highlighted it here before. But the Bank’s problem went deeper. It found itself snookered in monetary policy terms. Had it raised rates early enough to head off inflation, it would have had to do so when the economy was still in the grip of the pandemic recession, probably in late 2020 or early 2021, when the UK had not yet reached the end of the series of Covid lockdowns. Not wanting to hike too soon meant that it clung to the view that the inflation we were seeing was temporary or “transitory”

Had the Bank raised rates in mid-2021, when we know the economy was bouncing back strongly, or called an end then to QE (as argued for strongly here), it would have gained some later brownie points, though it might have been criticised at the time. Its own work, however, suggests that starting in the middle of 2021 would have made very little difference to the subsequent course of inflation.

As we reach the end of this period in which rates have found their way back to levels prevailing before the financial crisis, breaking decisively out of what some call the Zirp (zero interest rate policy) era, this is perhaps the most disturbing conclusion.

It suggests that, despite the flurry of activity we have seen, the Bank and other central banks were powerless to prevent much of the inflation shock that we have seen from playing out in the way that it has. The combination of the post-pandemic reopening of the global economy, supply chain disruptions and the Russian invasion of Ukraine was bound to give us higher inflation. All that the Bank could do was to attempt to prevent that inflation from becoming embedded. That is why it has been so concerned about wage growth and other so-called “second round” effects.

Has it succeeded in that? We will not know about that until the turn of the year, when it becomes clearer how next year’s pay round is shaping up. Thursday’s pause leaves the Bank with the freedom to raise rates should the next wage round be too high for its comfort. That is why, while I think rates have peaked, that depends on pay more than anything..