Bank of England's poor inflation forecasts have caused real financial pain
For 15 years very few have had reason to think about inflation and interest rates.
A generation of mortgage-holders have barely experienced rising payments. This is why the current situation is causing consternation and pain. The problem stems from the Bank of England being well behind the curve in raising rates – and thereby increasing the risk of ‘overkill’ as it now tries to bring inflation under control, as the makings of inflation have been around for a while.
In the Alice in Wonderland world of Quantitative Easing (QE), economic reality and asset prices get distorted. The early rounds of QE saw the money printed largely soaked up by the banks to restore balance sheets crippled during the financial crisis. However, the surge in QE during 2020 saw the money printed reaching the front-line economy. Money supply growth, in excess of that required by real GDP, surged. This began to affect prices.
Next time inflation is heading towards six per cent, let us hope there is less hubris
Other inflationary factors were evident. Courtesy of the pandemic and a changing geo-political landscape, business supply chains were being shortened – terms like “onshoring” or “friend-shoring” were in use. The ‘just in time’ model was being replaced with ‘just in case’ to better control production. This also contributes to the sourcing of cheap labour becoming more difficult.
Yet central banks were relaxed. Early signs of inflation were ignored. When inflation became increasingly evident, it was going to be transitory. And when the genie was out of the bottle, inflation would fall rapidly by the year end. A pattern begins to develop. In a recent session of the Treasury Select Committee, I described this as a woeful neglect of duty.
The Bank of England justifies its inaction by pointing to supply shocks. This does not explain why, a month before the invasion of Ukraine, inflation stood at 6.2 per cent (three times its target) while interest rates remained at 0.5 per cent. The problem now is that, while inflation will fall somewhat as one-off price increases fall away, inflation is set to remain stickier and more volatile than hitherto.
The deflationary force that is globalisation stalling – the new balance between capital and labour – an ageing population gradually shrinking the available supply of labour, and the nuances that facilitate international relations hardening, are some of the reasons. Meanwhile, interest rates are a blunter tool than hitherto in part because the number of mortgages has fallen markedly, and the balance is increasingly fixed rate. Persistent labour shortages, seen in many countries, will also act naturally to drive up wages.
And this brings us back to the politics. Despite cautioning as to the risks posed by even small rises in inflation in the budget of March 2021, the Prime Minister’s priority of now halving inflation by the year-end no longer looks the safe bet it did when promised. Meanwhile, whilst some central banks have paused their hikes, the Bank surprised many by its decision to raise out interest rates by 50 basis points to five per cent as it continues to play catch-up. This is causing real financial pain to households across the country and risks going too far.
Though opposition parties criticise the government, it’s not clear that they have any better solutions. Control of interest rates is in the hands of the independent Bank of England. There is very little appetite to change this setup, in part because it gives confidence that the government is not going to start interfering for political ends. Various initiatives are being mooted including mortgage tax relief (which excludes expensive properties). Given the government’s improving finances, cutting VAT is a more immediate option.
The Bank has finally announced it is conducting a review into how it forecasts inflation. It needs to bring its modelling up to date. The issues go well beyond the governor – confidence in the MPC generally is low. Factors such as shortened supply chains, geo-political realities and money-supply figures need to be woven into the fabric – for example, the subject of money-supply should be reintroduced into the MPC Report.
There needs to be less ‘groupthink’. Perhaps fewer economists and more questioning of the consensus is needed. A longer timeframe is certainly needed when learning the lessons of history. Instead of just focussing on the last 30-40 years, the MPC may have gained insight from understanding that during the last 100 years there has never been a period when inflation fell to more normal levels within two years of spiking into double figures. It might have prompted the question: “What’s different this time?”
There also needs to be humility – an often-underrated quality. As economist JK Galbraith famously observed, “the only function of economic forecasting is to make astrology look respectable”. Next time inflation is heading towards six per cent, let us hope there is less hubris and the MPC starts increasing rates more proactively. Interest rates of 0.5 per cent were clearly inadequate. Whatever the tea leaves suggest, perhaps a much smaller margin should be tolerated in future? It might save a lot of pain later.
John Baron, Conservative MP for Basildon and Billericay
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