Governor of the Bank of England Andrew Bailey (Toby Melville/PA)
(Picture: PA Wire)How many times over the past two years has the Bank of England forecast a significant, lasting problem with inflation? The answer is “never”. Yes, the Bank is prepared to accept that inflation might be rather punchy at any one moment in time. The Bank will even acknowledge that inflation might still be rather high 12 months down the road. But in two years’ time? Never.
This longer horizon is important because the Bank believes the full impact of interest rate decisions made today will only be felt in two years’ time. All sorts of random events can affect inflation in the near-term term – Covid-related supply shortages, invasions of neighbouring states by malevolent forces – but over the longer term, it’s monetary policy that matters.
There is, however, a rather obvious problem with this approach. The Bank, it seems, can never be wrong. Indeed, its own projections — based on financial market expectations of future policy rates — mostly confirm as much. Inflation will only stray from the Bank’s two per cent target if either, first, the Bank itself thinks those financial market projections are wrong or, second, there is unforeseen random future inflationary “noise”.
Consider, for example, the Bank’s inflation forecast made in November 2020. Back then, the Bank thought inflation today would be — you’ve guessed it — two per cent. Six months later, by which time actual inflation was on the rise, the Bank’s two-year-ahead forecast was — again — two per cent.
Despite the relentless further acceleration of actual inflation since then, the two-year-ahead forecast has remained stubbornly at around two per cent. Until now, that is. In its November 2022 Monetary Policy Report, the Bank forecast an inflation rate two years from now of only 1.4 per cent before heading to 0.0 per cent at the end of 2025.
Admittedly, the Bank publishes a “fan chart” of possible inflation outcomes around this “central projection”. Central bank infallibility, it turns out, is not quite papal. The message, however, is clear. While inflation is currently too high, it will be too low if policy rates rise as much as investors currently expect.
You might think it perverse that, in a world of excessive inflation, the Bank is more fearful of an undershoot than an overshoot of its inflation target. You might even wonder why the Bank is convinced that policy rates won’t rise as much as investors fear, given the inflationary overshoots seen to date.
In truth, the Bank has ended up in this decidedly odd position because of the fallout from the Truss/Kwarteng mini-budget fiasco. That led to higher gilt yields, higher mortgage rates and, as the Bank sees it, an unwarranted further tightening of monetary and financial conditions. Add to all this the likelihood that Chancellor Jeremy Hunt’s forthcoming “mini-budget” is set to be of the hair-shirt variety and it’s fairly obvious that the outlook for economic activity has deteriorated.
Whether this means inflation will end up below target if the Bank raises rates as investors feared last week is, however, another matter altogether. The lesson to be drawn from the past two years is not that inflation currently is a consequence of too much demand. The UK economy has, after all, hardly been roaring. Rather, price pressures reflect both too little supply (thank the fallout from Covid and the consequences for energy prices of Vladimir Putin’s activities) and, frankly, overly persistent monetary stimulus. The Bank’s continued refusal to concede that there was any kind of inflation threat in late 2020 and through much of 2021 — a view shared by its peers on either side of the Atlantic — meant policy rates rose only belatedly, by which time inflation was already more clearly established.
The big issue for inflation, therefore, is not whether the economy shrinks in line with the Bank’s fears — its forecasters are projecting a very long yet very mild recession — but, rather, whether inflation comes down sufficiently quickly in the light of an extended period of economic weakness. Over the past few decades, small interest rate tweaks and modest changes in demand have been sufficient to bring inflation to heel. Current economic conditions, however, carry echoes of the Seventies. As Paul Volcker, the late former chairman of the Fed, once said, “the best results [in delivering price stability] will be achieved if the inflationary threat is dealt with at an early stage…” Sadly, that ship has already sailed.
