Officials at the Bank of England will be watching the progress of the race to replace Boris Johnson as Tory leader and prime minister with rapt attention.
In normal times, central banks are supposed to pay little regard to the political gyrations that keep politicians occupied in Westminster’s tea rooms and bars. These are not normal times. Inflation has hit 9.1% and Bank staff are under pressure to push up interest rates to squeeze the economy and with it the inflationary pressures driving prices higher.
Before last week’s political drama unfolded, Johnson and his now-former chancellor Rishi Sunak had been scheduled to hold a press conference this week spelling out how the government’s tax and spending policies would develop over the next six months.
In his resignation speech on Tuesday night, Sunak said he had been unable to agree a path forward with Johnson, who wanted to announce bigger spending on defence and welfare. Sunak could not support this if it was not funded by tax rises. It is understood that Johnson wanted to marry his extra spending with tax cuts, increasing the amount of money that would be pumped into the economy.
Sunak argued with No 10 that economics at the moment was a zero-sum game. Any increases in spending would be deemed by the Bank as inflationary, spurring Threadneedle Street to increase borrowing costs even further than previously estimated.
Now that same debate will be played out, not between foes in No 10 and No 11 Downing Street, but between rival candidates in an election campaign to succeed Johnson.
Last week, the Bank’s chief economist, Huw Pill, said a change of policy meant it had ditched its adherence to a policy of “further tightening”, under which the Bank would increase the cost of borrowing in small and steady increments, in favour of a more flexible policy that could result in bigger jumps in interest rates. “Acting to achieve the [monetary policy committee’s] 2% inflation target is now more important than ever,” he said. “The MPC is committed to returning inflation to target in a sustainable way over the medium term. In the first instance, that has required – and still requires – tighter monetary policy.”
Pill said he was concerned that the UK economy was slowing and might suffer a contraction – a development that would persuade him to pause or even cut rates. “But it also requires that tightening be measured and proportionate, calibrated appropriately to the economic situation at hand,” he added.
It is possible that when the annual energy price cap increases by a further £800 in October to about £2,800, inflation will have topped 11% and the cost of living crisis will have taken a turn for the worse.
However, other factors come into play, including the government, under its new leader, suddenly pumping billions into the economy via tax cuts and welfare spending. Handing people extra spending power would drive prices higher when the supply of goods and services is constrained by a shortage of workers and difficult-to-obtain imports.
Pill refused to comment on the prospect of changes in government spending policy during a question and answer session at the King’s College global banking and finance conference in London last week, but his championing of greater flexibility in the Bank’s response indicates that he and his colleagues will be watching Westminster closely.
Catherine Mann, Pill’s colleague on the Bank’s monetary policy committee, is already itching to raise the 1.25% base rate faster towards what many City economists believe could be 3% by the end of next year.
Mann is concerned about a 12% tumble in the value of the pound since January, with much of its fall blamed on the UK’s lacklustre recovery from the pandemic. She blames a lot of the rise in inflation on rising import costs flowing from a weaker currency.
But without a coherent and wide-ranging plan from a new Tory leader that investors can agree is going to build a sustainable path to growth, the pound may fall yet further, putting even more pressure on the central bank to raise rates.
