Has the BoE lost its inflation fighting credibility?

March 21, 2023 - The UK’s October 2022 inflation figure printed at a 40-yr high of 11.1%, highlighting the strength of pricing pressures being experienced in the UK. With real wages falling, pressure is being felt not just by the Bank of England (BoE) to bring inflation back under control, but also by the UK government as it tries to find ways to shield households from this erosion in living standards.

For the BoE, this failure to control inflation has seen its role as the UK’s monetary guardian questioned. Admittedly, a significant element of the pricing pressures seen have their origins overseas, such as the increases seen in global energy prices and Covid-disrupted supply chains. But the BoE cannot hide from the fact that as recently as just over one year ago, the Monetary Policy Committee (MPC) was continuing to claim that inflationary pressures were transitory and that CPI would fall back to target of its own accord, given time, without the need for an aggressive monetary response. Even when the market was warning that inflationary pressures were becoming increasingly embedded, the MPC chose to ignore them and instead do nothing, remaining convinced by its own arguments.

Accelerating inflation

The result of this inaction was clearly seen in 2021, when CPI accelerated from 0.7% in the January to 5.4% by December, a level nearly three times higher than the BoE’s mandated 2% target. Yet it was not until that December that the MPC finally accepted that inflationary pressures were not actually transitory but would require action to bring back under control. Its response was to hike interest rates by 0.15%, in hindsight a too small amount delivered too late, and which had minimal impact.

What makes the BoE’s policy response – or lack thereof – more puzzling is that 2020 had seen an unprecedented contraction in aggregate supply as Covid lockdown restrictions were imposed. At the same time, a huge boost to aggregate demand was subsequently provided by the UK government through various mechanisms such as the jobs furlough programme and the “eat out to help out” scheme. Combined with the supply chain distortions being seen at the time, it is difficult to understand why the MPC thought these supply and demand imbalances would not have led to a surge in inflation once lockdown restrictions were lifted. Even with the benefit of hindsight, the MPC allowed itself to get too far behind the policy curve; by the time it realised its mistake, the inflation genie had fled its bottle.

The consequences are now being felt

The damaging consequences of this policy error have been clearly felt over the past year. CPI exceeded forecasts some eight times in 2022 alone, climbing to 11.1% in October before starting to ease back again, albeit slowly. At the same time, real incomes have taken a battering and led to growing industrial unrest as trade unions have resorted to strike action to try and secure pay increases that at least match the rising cost of living. And while this has happened, so the MPC has been required to aggressively tighten policy, raising interest rates from 0.25% to 4.0% in just nine meetings and seeing the market now expecting a terminal rate of 4.50% to be reached by end-H1 this year. Any fears BoE officials may have been secretly harbouring that a lack of monetary action was risking inflation getting out of control were realised by the MPC.

Ultimately, the ‘transitory inflation’ story was rightly abandoned. But it left the MPC behind the curve in terms of where interest rates needed to be as inflation climbed higher. Even today, the real interest remains negative at -6.1%, suggesting there remains a need for further tightening still.

Did fears concerning growth stay the MPC’s hand?

One reason frequently offered for the timid response to fighting inflation has been the deteriorating UK growth outlook, the MPC unwilling to tighten policy for fear of exacerbating the expected economic slowdown. But supporting growth is not the MPC’s role; it is only required to ensure the 2% inflation target is met and is tasked with achieving that objective only: maximising economic output falls under the remit of the UK Treasury and fiscal policy, not the BoE.

Has the UK Government come to the BoE’s aid?

The most recent BoE forecast for CPI (February 2023) showed inflation on a downwards trajectory, falling to 3.0% by Q1 2024 and 1.0% by Q1 2025, if interest rates rise in line with market projections. A key factor behind this rapid deceleration may be the fallout from the Truss/Kwarteng ‘mini-budget’ of end-October 2022. Designed to boost UK output, the degree of new borrowing it required frightened the markets, triggering a rapid financial tightening as gilt yields soared and interest-rate sensitive products such as mortgage rates rose steeply. With the need to restore confidence in the UK economy suddenly paramount, the subsequent Sunak/Hunt fiscal statement delivered in the November cast any concerns about growth to the wind. Virtually all the easing measures in the Truss/Kwarteng budget were removed, but at a cost of also removing some £50bn-worth of demand from the economy via a policy of aggressive tax hikes. But crucially the key measure of capping household energy bills was retained, the NIESR estimating this measure alone will lower CPI over the course of 2023 by some 3%-4%. Not only did the November statement assist the BoE in removing demand from the economy, it also single-handedly lowered headline CPI. Possibly an argument can be made that the government inadvertently came to the BoE’s aid.

But it is under the BoE’s current stewardship that control of CPI has been lost

But this does not detract from the fact that it is under the BoE’s current stewardship that control over inflation has been lost. The previous BoE Chief Economist, Andy Haldane, warned repeatedly in 2021 that the MPC was being too lax in addressing the potential inflationary threats facing the UK. Yet he was ignored, including by current Governor Andrew Bailey, who was unwilling to acknowledge any kind of inflation threat and instead opted to continue with the policy of monetary stimulus. Even the modest easing in CPI seen since October is more likely the result of falling energy prices and easing global supply chains – things over which the BoE has no control – rather than a consequence of the tightening the Bailey-led MPC has belatedly delivered.

Does the BoE need a new hand on the tiller?

Bailey’s tenure as BoE Governor has not been a smooth one. Criticisms were made of him in his previous role as Chairman of the FCA and more latterly in his communications with the market over monetary policy and the need for wage restraint from lower paid sections of society. Under him, the BoE is meant to have the key ‘birds’ eye’ view on all things inflationary, afforded to it by the huge volume of official data it has access to that is not available to others. But if the BoE is unable to decipher and interpret this information correctly – incorrectly believing rising inflation was transitory rather than sustained - or allows the data to perhaps fit its own arguments, where does that leave the UK in its battle to control inflation? Perhaps it is time to pass responsibility for ensuring price stability on to another institution - or, at a minimum, to possibly put another person in charge at the helm of the BoE/MPC?