The Bank of England’s ’s reputation has rested on its monetary credibility. Its record on inflation, both in the period of quasi independence from 1992 to 1997, and in the decade following the granting of independence in 1997, was superb.
Its critics could attack it for failing to pay enough attention to asset prices, such as housing, though it was only tasked with targeting inflation. Even people who saw no good whatsoever in Gordon Brown had to concede his achievement in giving the Bank independence (and keeping Britain out of the euro).
That is now changing. Ministers expected all the grief this year to be about tax increases and spending cuts. Instead, their mailbags are full of concern about rising prices. Inflation was not meant to be a problem, other than that reflecting higher taxes such as Vat.
Now the worry is that on top of the fiscal tightening there will be a monetary tightening, higher interest rates, as well. The implicit contract between the government and the Bank – while one aggressive cuts the deficit the other keeps rates down – is under threat.
Last week’s inflation figures, showing consumer price inflation up from 3.3% to 3.7% in December even before the Vat hike, were bad. Though the measure of inflation I referred to last week, CPIY, consumer prices excluding indirect tax changes, is bang on the Bank’s target at 2%, that is of small comfort. CPI inflation, which the Bank is required to target, is about to go above 4% and could stay there most of the year. Most people in Britain set their inflation watches by the retail prices index. Retail price inflation rose from 4.7% to 4.8%.
The Bank’s credibility now hangs by a thread. Even its earlier reputation is being questioned; the argument being that it benefited from favourable international developments, including the “China effect” on prices of goods in the shops.
Only the fact that the labour market is weak (though it could have been a lot weaker) prevents these inflation rates being reflected in pay deals. The longer inflation remains high, the greater the risk of that occurring.
The Bank made two big errors. I would not have cut Bank rate to 0.5% in March 2009, arguing at the time that 2%, which would have equalled the lowest in the Bank’s 300-year plus history, was as low as was needed. Below 2% it was hard to see any benefit to borrowers.
But the Bank went further, arguing it needed to go as far as it possibly could. These very low rates, to be fair, helped the banks recover.
The mistake was allowing a 0.5% Bank rate, which it should have made clear was a temporary emergency rate – to be withdrawn as the economy recovered its footing – to become a new norm.
Perhaps the Bank did regard it as something like the new norm; at the time it predicted average inflation of 1% through to 2012. But it is very dangerous when the exceptional becomes commonplace.
As I wrote in March 2009: “The Bank has to be ready to raise rates as quickly as it cut to avert any medium-term inflation problem. It would also give a powerful signal that the worst was over.”
The second big mistake was the Bank’s failure to look beyond the crisis. Britain’s inflation problem is a product of two factors: the sharp fall in the exchange rate that began shortly after the crisis broke in the autumn of 2007 and the post-crisis rebound in commodity prices.
Even if the Bank did not foresee the extent of these factors, and in the case of sterling there is little excuse, it should have been alert to the possibilities. A few well-placed warnings of extreme inflation volatility would have countered the impression that the Bank has been completely caught out.
As it was, two years ago in its February 2009 inflation report, the Bank saw no chance at all that inflation would be above 3% now, though it did see a small possibility that economic growth would be 5.5% or more.
Sharp-eyed readers will notice I have not blamed the Bank for its £200 billion of quantitative easing. Though it would be easy to blame “printing money” for current high inflation, there is no evidence to support that.
For that, quantitative easing would have had to either boost the money supply significantly or contributed to a sharp weakening of the pound. Neither has occurred. Sterling’s big fall happened before the Bank embarked on its easing policy.
What should the Bank do now to try to restore its reputation? The easy thing, it would seem, would be to start raising interest rates. The problem with that is that it is too late now to have much impact on inflation over the next 12 months, even if it were the case that the drivers of inflation were domestic – and in the Bank’s sphere of control – rather than international, or tax-induced.
A rate hike last June, when Andrew Sentance first voted for it on the MPC, would have been ahead of the curve. Anything the Bank does now would be regarded as a belated response to an inflation problem it failed to predict. Hiking interest rates could push up the pound in the short-term but, to the extent it damaged recovery prospects, the effect would be short-lived.
So the Bank probably has no choice but to see its experiment with ultra-low interest rates through, to hope that some of the current pressures will abate and that inflation will find its way back to 2%. Whether it ever gets its reputation back is another issue.
My regular column is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.
Originally published at David Smith’s EconomicsUK and reproduced here with permission.