Why the Bank of England must not bow to pressure to tighten monetary policy

After keeping interest rates unchanged for 17 months and maintaining its quantitative easing (QE) programme since November 2020, all eyes are back on the Bank of England this week thanks to a confluence of events.

Inflation has risen to 2.5 per cent, above its target of 2.0 per cent. Blockages and delays in the supply chain due, in part, to both the Covid-19 “pingdemic”, that has confined key workers to their homes, and the long-term impacts of Brexit are likely to push prices up further: the Bank’s recently-departed chief economist Andy Haldane thinks inflation could soar to 4 per cent by the end of the year.

New coronavirus case numbers have begun to fall while deaths and hospitalisations have remained low. The International Monetary Fund (IMF) has forecast that the economy will post the joint-fastest growth in the G7 in 2021 at 7 per cent.

As Hande Kucuk, the deputy director for macroeconomic modelling and forecasting at the National Institute of Economic and Social Research (NIESR), an independent think tank, puts it: “This is a crucial week for the Bank of England to step in and say, ‘we are watching how widespread the rising inflation will be’.”

There are two issues here: when should the Bank start tightening monetary policy? And when it does eventually withdraw the economic stimulus which tool should it use first — raise interest rates or reduce QE?

Some people have called for action on Thursday: that would be a mistake. Thankfully the Bank’s Monetary Policy Committee (MPC) is expected to keep policy unchanged and repeat its message from June that it will avoid any unwarranted policy tightening so early in any recovery.

There are good reasons for that. There is still much uncertainty over the potential spread of coronavirus as the recent spike in cases has shown. The impact of the phasing out of the job retention scheme (or furlough) is another uncertainty. Governor Andrew Bailey has said it would be wrong to overreact to temporarily high growth and inflation — a sentiment echoed by his colleague Jonathan Haskel’s reference to “transitory” inflation pressures.

But if not now, then when? The reason the Bank is expected to set out its thinking is that its policymakers have hinted as much. In July the House of Lords’ economics committee said the Bank of England was “unclear” on whether it intends to raise interest rates or unwind QE first.

Deputy governor Ben Broadbent said this month that financial markets would learn the Bank’s thoughts “soon enough”. This week also sees the Bank publish its Monetary Policy Review (MPR), adding to expectations.

The Bank’s current guidance dating back to June 2018 is that it will not start reducing QE until rates have risen to at least 1.5 per cent, implying reducing QE would come way after rates started to rise.

It has three options: keep the order unchanged but reduce the threshold at which QE reduction can begin; lower the threshold and allow quantitative tightening (QT) to happen at the same time: or remove the rates threshold altogether.

George Buckley, European economist at Nomura bank, expects the Bank to go for the third option and remove the threshold to begin quantitative tightening. Last year Bailey himself said in an article for Bloomberg that it “may be better to consider adjusting the level of reserves first without waiting to raise interest rates on a sustained basis”.

That seems the wisest course of action. It has been well documented that QE inflated asset prices artificially, disproportionately benefiting those who own them and in turn exacerbating wealth inequalities.

The Lords’ economics committee said the evidence showed QE had had a limited impact on growth and aggregate demand over the last decade. “There is limited evidence that quantitative easing had increased bank lending, investment, or that it had increased consumer spending by asset holders,” its report said.

Equally, raising interest rates would directly hurt businesses and households that have taken advantage of low interest rates to borrow money in face of the impacts of the pandemic.

Whatever they do, communication is key. As Kucuk points out, there has not been much experience with the unwinding of QE. “They have this tricky balance of doing enough to anchor inflation expectations without creating an overreaction from financial markets,” she says. “It requires really gradual steps.”

Back in the Bank’s Victorian-era heyday, it used to be said the governor could influence behaviour by raising his eyebrows. The focus should be on communications rather than action, but some clear words are in order.