The Bank of England must have the courage of its convictions

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At this stage in the inflationary process, a central bank needs to show moral fibre. Last week’s 0.5 percentage point rise in the Bank of England’s intervention rate was unquestionably necessary. It may even be that the resulting 5 per cent rate will not be the peak. Nevertheless, doing whatever it takes to bring inflation to target is more than merely desirable, it is the bank’s legal duty. Nobody on the Monetary Policy Committee is free to ignore this obligation.

It is also by now impossible to persist with the fancy that what is going on in the UK is no more than a temporary bout of imported inflation. The latter was always likely to launch an inflationary process. So, indeed, it has. Annual core inflation (which excludes food and energy prices) was 7.1 per cent in the UK in the year to May, services inflation was 7.4 per cent and the three-month moving average annual growth of private sector pay (excluding bonuses) in April was as high as 7.5 per cent.

Such a rate of pay rises is not surprising. In April, real average weekly earnings were 4 per cent below their level two years earlier and at the same level as in August 2007. The unemployment rate in the first quarter of 2023 was also only 3.9 per cent. This indicates a pretty tight labour market. Why, in these circumstances, would anybody expect workers to accept large reductions in real earnings? At the same time, current rates of pay inflation are clearly incompatible with 2 per cent inflation.

Something has to change, radically and soon. We are seeing a price-price and wage-price spiral radiating throughout the economy. The only way to halt this is to remove the accommodating demand. In other words, the question is not whether there will be a recession; it is rather whether there needs to be one, if the spiral is to be halted. The plausible view is that the answer to the latter part of this question is “yes”. Like it or not (I certainly do not), the economy will not get back to 2 per cent inflation without a sharp slowdown and higher unemployment.

This raises four questions.

The first is whether current monetary policy is tight enough. The argument that it might be is that borrowers are highly vulnerable to higher nominal interest rates, after a long period of ultra-low rates. Against this, today a 5 per cent nominal rate implies a real rate of less than minus 2 per cent. Moreover, the squeeze will come quite slowly. According to the Financial Conduct Authority, in the second half of 2021, 74 per cent of mortgages were at interest rates fixed for between two and five years. In sum, rates may have to rise again.

The second is whether the government should cushion the blow to borrowers. The answer is: absolutely not. One reason is that people with large mortgages are relatively well off, as Torsten Bell of the Resolution Foundation points out. The right policy is rather targeted assistance for the most vulnerable. Another reason is that this would defeat the object of the exercise, which is to tighten demand. If fiscal policy were to offset this, monetary policy would have to be still tighter than otherwise. If the desire is to moderate the monetary squeeze, fiscal policy should be tightened, not loosened.

The third is whether the uncertainty that surrounds all these decisions should itself encourage extreme caution in tightening. Unfortunately, it is not so simple. True, there exists much uncertainty about the strength of the underlying inflationary pressure and so about how deep an economic slowdown is needed to bring it under control. There exists, similarly, much uncertainty about how much tightening is needed to bring about such a slowdown. But if one is determined to bring inflation back to target in the near future (that is, in less than two years), it is untrue that the smaller mistake would be to err on the side of optimism about how easily inflation will fall. Doing less would reduce the slowdown now. But, if it failed to deliver the needed fall in inflation, a still bigger slowdown might be needed later on, when inflation would be still more entrenched.

The last question is whether it is worth the effort: why not just give up on the target and accept, say, 4 or 5 per cent inflation? The answer is that if a country abandons its solemn promise to stabilise the value of the currency as soon as it becomes hard to deliver, other commitments must also be devalued. At home and abroad, many will conclude that the UK is unable to keep its promises when things get tough. That is what happened, to a significant degree, in the course of the 1970s: the UK started to be a joke. To repeat this, particularly after Brexit, would be an unpardonable — possibly even incurable — folly.

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