The Bank of England’s caution risks burning us all

The Bank of England, on the whole, doesn’t like to spring surprises. A surprise usually betokens crisis, and crisis means the Bank hasn’t been doing its job.

So, given that there was no emergency and thus no cause to transmit some “shock and awe” message to consumers, businesses and financial markets, the long-expected further increase in Bank rates of a quarter of a percentage point to 4.5 per cent was carefully pitched.

Had the Bank paused its policy of gradually taking its preferred “baby steps” to restrain inflation and return the policy rate to normal, it would have signalled either some lack of resolve or else some panicky response to an unforeseen danger to economic activity or financial stability.

On the other hand, if the Bank had heeded its most hawkish critics and plumped for a half percentage point rise, just to show it meant business, that would have transmitted some inkling that inflation really was proving very stubborn to treatment. So the move – well anticipated and moderate, and tracing a clear, gentle but determined trajectory upwards – was a model of central bank tactics.

That said, as the governor of the Bank, Andrew Bailey, put it with admirable simplicity: inflation remains too high, at more than 10 per cent. This is the case in relation to the Bank’s official target of 2 per cent, and when set against most international comparators.

It is not coming down quite as rapidly as the Bank might have hoped and is proving “sticky”, with core inflation, stripping out volatile items as such as fuel and foodstuffs, at an uncomfortably high 6 per cent on the latest readings. That, in turn, reflects the present shortage of labour pushing wage costs higher; a consequence of Brexit, long Covid and a trend towards early retirement. “Homegrown” inflation has become an issue in a way it hasn’t been since the early 1990s.

Such is the (relatively) strong performance of the economy that the Bank’s Monetary Policy Committee (MPC) has also upgraded its growth forecasts and confirmed that the UK will avoid a recession this year.

Unemployment is low and wage rises high. The economy is still suffering from the supply shocks caused by leaving the EU, the war in Ukraine and post-pandemic disruptions to supply chains. It is thus running at near-capacity, but a smaller capacity, in relation to the usual rates of growth, than existed in, say, 2019. Something has to give.

The best response, theoretically, to such a circumstance in the short term would be to act on the supply side of the economy and reverse Brexit, issue more migrant visas, cure long Covid and force retirees back to work. Given that such policy levers haven’t been offered to the Bank of England, or to the Treasury, tax hikes and interest rate rises are the only weapons available, and they will have to be wielded with some force for the desired effect. That is why rates have risen so steeply.

So, such buoyant demand as exists now in the face of restricted supply of everything from bar staff to semiconductors to natural gas is a bad omen for getting inflation down as fast as the Bank and the government would wish. As such, the price will be paid by homeowners and businesses facing higher borrowing costs over the next few months.

The Bank has spied the continuing danger and it is also expected to take further action on rates if underlying inflation does not subside in response to the 12 increases in Bank rates since last year. A Bank rate of 5 per cent could not be ruled out by the end of the year if it seemed that inflation is becoming embedded in wage-bargaining behaviour, and being passed on too readily to consumers with price rises in the shops.

This leaves us with a question: is the Bank being too impatient and running the risk of overdoing it? Much of the cost-push inflation in energy and food prices seen since the Russian invasion of Ukraine should moderate over the course of the next year in any case, as a statistical artefact, and interest rate rises cannot be expected to have any great immediate effect – they make their presence felt with famously long and variable lags as they work their way through the economy.

Inflation cannot be returned to 2 per cent in a matter of weeks, even if the Bank were to induce a huge economic slump. Pushing interest rates up too fast too soon when there is every chance that inflation will subside “naturally” means that when the rate rises reach their crescendo, inflation will already be headed firmly towards its target rate (and may well have already reached it).

It is rather like someone in a shower ramming the temperature control up to maximum just because the warmer water hasn’t quite made its way through the pipes to the shower head, with predictable scorching effects that would be avoided with a little more caution and perseverance. In the real world, ramming rates up too high too fast means an even tighter squeeze than necessary on borrowers and firms looking to finance investment, and much misery yet to come.

With the tax hikes already implemented and continuing inflation, despite the current fiscal and monetary contraction, living standards look certain to at least stagnate in the short to medium term. That is what the Bank’s chief economist, Huw Pill, meant when he advised the British to accept that they are poorer.

It is possible that the economy will return to growth – though it will be minimal – and inflation could halve over 2023, fulfilling two of Mr Sunak’s key pledges. Yet at the same time, property prices might fall, and bankruptcies and unemployment edge higher than needs be, even if a recession is averted. Politically, those are dangerous headlines for a government seeking re-election.

Whether the Bank kept monetary policy too loose for too long, all the way from the global financial crisis in 2009 through Brexit to the pandemic, is something the monetary analysts and economic historians may debate at their leisure. The fact is that the Bank could see none of these crises coming, and has had to make decisions based on the hand it has been dealt: Vladimir Putin was never going to check things out with the MPC before issuing his battle orders.

Perhaps with one eye subconsciously on Rishi Sunak’s political target of inflation at 5 to 6 per cent this year, and fearful of its own reputation and cherished operational independence, the Bank is making sure that no one thinks it is soft on inflation.

Given Britain’s unhappy historical experience of inflation, and the evidence of its becoming endemic again, the Bank is understandably erring on the side of caution in pursuing its remit, but there is also a sense – and a fear – that it is going to scald the rest of us along the way.