The Bank of England is facing fierce criticism from both sides over its plans to raise interest rates. For hawkish economists, Threadneedle Street has fallen badly behind the curve, miscalculating the rise of inflationary pressures, and now needs to play catch-up to regain credibility.
Others say the Bank is navigating the most dangerous moment for the economy in decades, but now risks a huge policy mistake. They argue that driving up borrowing costs will have little effect on inflation caused by global supply chain disruption, and that it risks engineering the conditions for a recession in an economy still grappling with Covid-19 and struggling for momentum.
Each side fears that a lack of coherent strategy either way will fatally undermine the central bank’s credibility.
Behind the curve
Andrew Sentance, a former member of the Bank’s monetary policy committee (MPC), said a steady rise in interest rates last year, clearly communicated to financial markets, would have been a sensible reaction to rising prices, and he criticised the Bank for a kneejerk response. “They’ve sent conflicting messages on monetary policy since last November, and they seem to have lurched from being very cautious to being seen to want to act. But it’s still not clear what strategy they’re going to be following in the future.”
With inflation poised to hit more than triple the Bank’s 2% target rate come April – rising to about 7% – City investors are betting that the MPC will add several more interest rate rises to one in December and another this month in an attempt to restore its credibility after waiting and watching for too long last year. The Bank governor, Andrew Bailey, was criticised as being out of touch when he urged workers this month not to demand big pay rises.
Financial markets expect rates to reach 2% by the end of the year, the highest in more than a decade, since rates sank close to zero during the 2008 financial crisis.
Roger Bootle, chairman of the consultancy Capital Economics, told MPs on the Commons Treasury committee last week that the Bank was “way behind the curve”, breeding a mismatch between the degree of tightening of policy and how quickly the inflation danger was picking up. “The Bank has not communicated clearly enough how tough it may need to be,” he said.
Official figures are expected to confirm on Wednesday an inflation rate of close to 5.4% in January, the highest level in three decades. The Bank has said the measure for the annual increase in the cost of living could peak at about 7.25% by April as surging energy prices feed through.
“Out of the blue, for the first time in 20 years, inflation comes powering ahead, way above what they dreamed of, and they are like: ‘Oh my God,’” Jim O’Neill, the former Treasury minister who sits as a crossbench peer in the House of Lords, told MPs at the same hearing.
O’Neill, a former chief economist at Goldman Sachs, said acting too fast could exacerbate the damage. “At this point they have to get out of that dilemma, but they now run the classic risk, for those who have been around long enough, that they might end up going too much in completely the wrong way, just to get their own credibility back,” he said.
On the Bank’s own forecasts, it anticipates unemployment rising from the current rate of 4.1% to 5% by early 2025 as the economic outlook deteriorates due to weak real income growth and fading consumer demand. Helped by higher interest rates, inflation is forecast to fall back below target to 1.5%.
Despite the risks to the economy, Karen Ward, a former adviser to Philip Hammond when he was chancellor, and now the chief market strategist for Europe, the Middle East and Africa at JP Morgan Asset Management, said Threadneedle Street was still likely to prioritise protecting growth.
“They’re walking a tightrope between maintaining their credibility and showing that they will not tolerate such high inflation, but not being so heavy-handed that they short-circuit the recovery. On that balancing act, I feel they’ll err on the side of inflation rather than [damaging] growth” she said.
Hold your nerve
It’s possible to be too critical of policymakers when they are coping with a once-in-a-lifetime pandemic, said Neil Shearing, chief economist at the global consultancy Capital Economics.
“There is lots of gnashing of teeth about inflation at the moment. And there is an argument that governments and central banks have over-stimulated their economies, triggering higher prices than would have been the case. But in the 2008 financial crash they were rightly criticised for not providing enough stimulus, and that mistake led to a much worse situation in the years that followed.”
Dario Perkins, the head of global macroeconomics at the consultancy TS Lombard, said the BoE should not be blamed for the rise in inflation. He believes it was sensible to maintain ultra-low rates last year while the economy recovered from the pandemic. “However, the bank’s credibility is at stake now as it starts to increase interest rates without a good reason for doing so,” he said.
Ben Broadbent, the Bank’s deputy governor, has tackled criticism of the Bank head on, saying the economy was weak last year and continued to need low interest rates. He has justified the turnaround since December by arguing that the Bank needs to clamp down on early signs that workers, keen to limit the damage from rising inflation, are demanding higher wages, triggering a wage/price spiral.
Perkins, a senior Treasury economist during the 2008 crash, described the concern about spiralling wages variously as “ridiculous”, “spurious” and “fake”. It’s a view that goes to the heart of the Bank’s dilemma.
It also potentially undermines the credibility of the central bank’s regional agents, who underpin the Bank’s forecasts of future earnings and have reported that wage increases are already running hot across the country.
“I think with every move it makes, the MPC is trying to convince us that despite two years of unexplained policy changes, and despite appearing to embark on a new and undeclared policy of financing government debt, despite an economy showing no sign of above-average wage growth, it remains a credible and independent policymaking body,” said Perkins. “It is when this defensive mindset takes over that policy mistakes are possible.”
Rupert Harrison, George Osborne’s chief economic adviser from 2006 to 2015, said all central banks were in danger of making their first major mistake. “[It] really feels like central bankers around the world are making a collective policy mistake – trying to use rapid rate rises to cool inflation that is driven mainly by supply constraints, just as growth momentum is slowing,” he tweeted. “Only in the US can you see anything like the hot labour market that would justify significant tightening – I really struggle to understand the Bank of England’s reasoning today.”
Robert Skidelsky, a peer who sits on the Lords economics affairs committee, said the central bank was struggling to maintain a fiction that it was independent from Treasury policymaking. “It is terrified of losing its credibility as an independent central bank, but cannot admit that it has become like an agency of the Treasury. Now it is trying to act independently and yet its dual mission – to bring down inflation while also fostering growth – leaves its policymaking in disarray.”
Danny Blanchflower, a former member of theMPC, believes a series of missteps through the pandemic mean the Bank’s credibility is “totally shot”. He said: “Since the time the Bank was made independent [in 1997], I don’t think we’ve seen anything so bad.”
Blanchflower said higher unemployment was riskier than above-target inflation. “The danger is they’re going to generate a recession,” he said.