No easy answers for the Bank of England

Inflation must be conquered to regain public trust

A new generation in Britain has experienced the pain of high inflation. For a long time price stability has been taken for granted. Occasionally, in the past one might have heard the suggestion that a little bit of inflation would be no bad thing. Few people can think that now.

Inflation is a profound evil. It cheats savers, worsens living standards, promotes instability and labour unrest and undermines confidence. Inflation is the most important immediate problem we face. This is not to downplay growth, but we cannot have sustained growth without first getting on top of inflation. Sound finance, stability and low inflation are the preconditions for growth.

We should not be too downbeat about the UK’s economic growth. While the UK has barely recovered to its pre-Covid-19 level, unlike several major European countries, these are small differences in small numbers.

Some people talk about economic growth as though they are the first people to have thought of the idea. Of course, growth must be the ultimate objective of policy but it cannot just be conjured into existence by politicians snapping their fingers. There must be non-inflationary growth. Inflationary growth is pointless.

It is sometimes argued inflation benefits the government’s finances and that can sometimes be the case. But with interest rates high and a lot more indexed debt, I doubt the government views it that way. Debt interest in 2023-24 is estimated to be £114bn – almost as much as the state pension at £120bn. As a percentage of government revenue and gross domestic product debt, interest is approaching record highs of nearly 12% and 5%.

The May figures for inflation of 8.7% in the UK were very disappointing. Inflation stopped falling, core inflation actually increased from 6.3% to 6.8%, and services inflation also increased. Annual wage growth rose to 7.2% compared with 5.2% in the euro area and the US. This suggests we run the risk of embedding the current inflation rate.

Is the UK an outlier in inflation? The rate is higher than that of France, Germany or the US but Italy is only marginally lower. Ten EU countries have higher consumer price index rates.

Some economists argue that the UK has ‘the worst of all worlds’ in that it suffered the energy shock of Europe and the labour shortages of the US. The unemployment rate is only 3.8% with a million vacancies.

What should the Bank do?

In response to the May Inflation figures, the Bank of England put up rates by a full half point. Some criticise this as one-club golf. But what are the alternatives? Price controls only tackle the symptoms and often reduce supply. Another alternative would be to tighten fiscal policy, putting up taxes or cutting spending. But this is a cumbersome process. Interest rates are more flexible and can be adjusted quickly in either direction in response to circumstance.

Others argue exactly the reverse. According to their approach the UK should pursue higher real incomes through economic growth and targeted tax cuts. But the hope that tax cuts and growth, if it materialised, would lessen demands for higher wages in the tight British labour market seems illusory. Such an approach plainly cannot be on the cards after last year’s mini budget. Challenging the current approach risks upsetting market confidence.

It would not make sense for monetary and fiscal policy to point in opposite directions at present. That need not always be the case with monetary and fiscal policy but is necessary now with a tight labour market.

It will be difficult to return inflation to the Bank of England’s target of 2% without some contraction in activity, but hopefully not a recession. The UK needs to realign demand with weaker supply. Of course, it also has to do all it can to increase supply, but whether that’s food, energy or components that takes time.

Understandably people are concerned about the impact on mortgages. Changes in the market to more fixed-rate deals mean that the impact of interest rate changes takes longer than in the past. Some 1.3m people have fixed-rate mortgages expiring in the 12 months from 1 July. So far the mortgage holders have been remarkably resilient. This generation of mortgages were lent more cautiously than in the past. The affordability tests imposed by the Bank of England mean that many borrowers already have a decent margin to cope with shocks, but flexibility and help from the banks as during Covid-19 will be necessary.

Some voices have called for a mortgage rescue package. But it is not sensible for the Bank of England to bear down inflation by raising rates and for the government to subsidise them at the same time. Nor is it equitable to ask those not owning houses and struggling with food and energy bills to subsidise those already on the housing ladder.

Rethinking relations with the Treasury

I continue to support the independence of the Bank of England, but the credibility of the bank is at risk. In the recent past it has not sounded, let alone acted, as though it was determined to defeat inflation. In 2021, the Bank continued with quantitative easing, even when it became inappropriate as prices accelerated and distortions in asset prices were obvious. When Andy Haldane, the Bank’s chief economist, warned the inflationary tiger was stirring, he was ignored. The Bank continued to call the rise in inflation transitory for far too long.

In fairness to the Bank, other central banks made similar misjudgements. Some critics argue the Bank should be partly reintegrated into the Treasury. That would not be sensible. Mistakes may have been made but that does not mean the input of politicians would improve decisions or that independence for central banks has failed.

Obviously there needs to be coordination of monetary and fiscal policy, especially if we ever return to QE. The chancellor of the exchequer already has to sign the total umbrella guarantee of the Treasury to the Bank when it wants the option of QE. Individual tranches of QE are for the Bank to decide. I doubt if the chancellor when he signs that umbrella guarantee does so without careful discussion with the Bank.

If the Bank is to regain the confidence of the public it needs to focus hard on its core objective of defeating inflation. Some people want to pretend there are easy answers but there are none. As the prime minister has said: if people know that something is too good to be true, then it is not true.

Lord Norman Lamont of Lerwick is a Conservative Member of the House of Lords and a member of the OMFIF Advisory Network. He was UK Chancellor of the Exchequer from 1990-93.

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