The Bank of England’s Monetary Policy Committee (MPC) has voted to cut interest rates. In what must feel like a novel experience for the MPC, it has finally made the correct decision. The MPC failed in its main task as it ignored the major warning signs and allowed inflation to get too high. This significantly contributed to the cost of living crisis and pushed millions of households into poverty.
Once the MPC finally decided to do its job it again fumbled the bag. It increased interest rates too far and kept them high for too long. Again it ignored all the warning signs both in terms of inflation being projected to fall below target and the impact on the real economy in terms of sluggish growth and rising unemployment. The MPC should never have raised interest rates above five per cent and it should have started cutting them and abandoning Quantitative Tightening months ago.
While the MPC might have finally done the right thing by cutting interest rates, it has been far too cautious by cutting Bank Rate from 5.25% to 5%. It should have been much bolder by making a bigger cut and reducing Bank Rate to 4.25%. This is for a number of reasons.
Today also saw the release of the Bank’s quarterly inflation report. While Bank officials and the new government might be happy that inflation has finally returned to target, there are warning signs that the economy is in for tough times. For example, although inflation might rise above inflation in the short term, it is projected to actually fall below target in the medium term which would suggest a lack of demand in the economy.
A more drastic cut to Bank Rate is also necessary in order to protect jobs. By historical standards the UK has experienced a tight labour market for a number of years. However, lots of the indicators have been suggesting for a number of months that things are beginning to slacken with the unemployment rate increasing.
While mass unemployment is unlikely, people losing their jobs is a disaster for them and their families. It also has knock-on effects on the rest of the economy as losing your job or being worried that you might means you spend less money on non-essential items. This is obviously bad for businesses who will see their profits take a hit as well as the employees of those firms who might find themselves at risk of becoming unemployed. All of this would mean that a recession could be on the cards which is probably the last thing the new government wants to deal with.
Cutting Bank Rate to 4.25% would also more accurately reflect the actual state of the economy. The growth of the country’s Broad Money M4 supply has slowed significantly over the past 12 months. This is important because although inflation is complicated, the great economist Milton Friedman – who would have turned 112 yesterday – was essentially right when he said that ‘Inflation is always and everywhere a monetary phenomenon’.
There were supply side factors at play which were not the Bank’s responsibility. When it came to the recent spike in inflation there were supply factors at play which were not the Bank’s responsibility, but it did allow money supply growth to get out of control. We have seen for some time that this has now slowed and so it is not surprising that inflation has also dropped dramatically.
Finally, lowering Bank Rate to 4.25% would be much closer to the real interest rate. Gilt yields seem to suggest that the long term real interest rate is around 4% and so there is no reason for Bank Rate to be set so much higher.
All of this means that the MPC needs to be much bolder. It should have made the difficult decision of increasing interest rates much earlier in order to stop inflation from getting out of control. It should then have been much bolder in cutting rates earlier even if that looked risky. It has finally done the right thing but far too slowly and not to the necessary extent.
While it is right that the MPC remains independent of government, its decisions have a huge impact on our lives and so it crucial that it makes the right ones. Its repeated failures have contributed to incredibly high inflation and sluggish economic growth which has caused misery for millions of households. Today it has failed to be bold enough which will have far reaching consequences for the economy. If Rachel Reeves is serious about delivering sustainable economic growth then she should consider firing Andrew Bailey and bringing in fresh leadership to the Bank of England.
Ben Ramanauskas is an economist. He previously worked in academia and as an advisor to the UK government.
