The politics of inflation are basically about blame

There are few things that are certain in economics, but given everything that’s happening, it is unlikely that the policymakers at the Bank of England have got the latest interest rate judgement right. The lingering after-effects of Brexit, the supply-chain difficulties after Covid-19, and now a war in Europe and global economic war on Russia mean that such judgements are ridiculously clouded by uncertainties.

Who can say where the economy might be heading in 18 months to two years’ time, the kind of time horizon the Bank’s Monetary Policy Committee (MPC) has to look to? Another wave of severe Covid? An escalation of the war? A property crash in China? More freakish weather affecting harvests? They’d be very lucky to get it “right”.

If, over the next few months, inflation persists at high levels – and the perception is that the Bank has failed in its central mission to keep to a target of 2 per cent inflation and generally protect the economy – then the political consequences for the Bank may be dramatic, in the form of a (more or less) drastic reduction in the operational independence granted to it by the New Labour government back in 1997.

In extremis, a populist government led by Boris Johnson wouldn’t think twice about “taking back control” over the cost of mortgages, and grabbing back such an important economic lever during a cost of living crisis. It might be argued that the Bank was setting rates too high to “build back better” and “level up”, whatever those slogans mean. The judicious use of pre-election interest-rate cuts would also tempt Mr Johnson, who will soon regain the ability to call a general election at a time of his own choosing (when the 2011 Fixed-term Parliaments Act is finally repealed).

Cutting mortgage rates is certainly something that has helped prime ministers win elections in the past, along with tax cuts to help engineer a pre-election boom – the trick being to ramp rates and taxes back up after polling day. The only good thing, from a politician’s point of view, about leaving the Bank of England to run monetary policy is that its governor can take the blame, and the abuse, for the tough calls and the hit to living standards. But that deflection of blame has its limits if a government has found itself deeply unpopular for a variety of reasons, and if voters aren’t listening to excuses.

The return of “stagflation” – a toxic combination of sluggish growth and rapidly rising bills – would be electoral poison as well as a huge economic headache. We may well find this term cropping up again, as the effects of the spike in global commodity prices and shortages of labour spread inflation through every sector of the economy.

Given the uncertainties and geopolitical risks attached to the cost of energy in particular, it is perfectly possible that the annual rate of consumer price inflation might hit 10 per cent in the coming months, with wages no longer keeping pace. Indeed, it is already at almost 8 per cent on the older Retail Price Index, against a still-elevated 5.5 per cent according to the Consumer Price Index, which takes less account of housing costs. We’re looking at inflation hitting 40-year highs, basically.

Such inflation rates will be tragi-comically higher than the official 2 per cent target, and will shred the remaining credibility of the MPC. A key factor in the Bank’s decisions is whether wage demands begin to respond to rising prices, and inflationary expectations start to be established throughout the economy. The pandemic and the furlough scheme made that impossible to detect, but it may well happen, given that there is no end in sight to the energy crisis.

Signs that a wage-price spiral is becoming entrenched will prompt the MPC to make more violent hikes in rates (though they’ll still be at historically low levels). That will hurt, economically and politically, especially for those who’ve stretched themselves in the booming housing market (once their tempting starter-mortgage deals run out).

The most unfortunate thing for the Bank is that its three main instruments for taming inflation are all to do with the demand side of the economy – interest rates; “printing money”, known as quantitative easing; and varying the way banks lend to consumers, such as tightening mortgage conditions. Normally these work very smoothly, and in the first ten years of the Bank’s independence, during the “great moderation”, managing excess demand and overheating could be achieved by pushing rates up and down by modest increments along a usually predictable path. The financial crisis of 2008 disrupted that, but the system righted itself remarkably quickly as the age of austerity ensued.

However, much of the UK’s inflation problem in recent years is not caused by traditional problems with consumer demand and confidence, but is rather to do with shortages and distortions to supply – the triple whammy of Brexit, Covid and war.

It means the Bank is in a poor position to fix things. The Bank’s governor, Andrew Bailey, actually admitted as much in his evidence to the Commons Treasury Committee last November: “By the way, monetary policy on its own – raising interest rates – is not, I am afraid, going to supply more gas or more computer chips. The risk for us is that we see in this recovery that the output gap is now approaching being closed, and the labour market in particular looks tight. That is the big issue at the moment.”

The problem, then, is that the authorities are like a golfer with only one club – and are using it to hammer demand in an economy where the real problem is poor supply, exacerbated by a long-term productivity problem. Mr Bailey’s sensible appeal for wage restraint – quite an antique concept in the 2020s – was gently slapped down by our boosterish prime minister. The politics of inflation are basically about blame.