NIESR top economist: Bank of England has tools to fight inflation
The UK economy is in a bit of a bind.
Households are being squeezed by historic rises in their living costs, while businesses’ margins are thinning due to expenses soaring.
A much higher than expected inflation crunch – primarily the result of Russia’s unforeseen invasion of Ukraine – is forecast to trigger a spending pull back which may shift the economy into reverse.
But, much of these downside spending risks have been offset by Chancellor Rishi Sunak’s cost of living care package.
In fact, the Resolution Foundation estimates around 80 per cent of the rise in living costs will be paid for by the government.
While necessary to prevent historic spending power declines in the UK – the National Institute of Economic and Social Research (NIESR) earlier this month said a further 250,000 Brits would tip into extreme poverty without government action – Sunak’s package adds uncertainty to the inflation outlook.
Prices are already nine per cent higher than they were a year ago, the fastest acceleration since 1982. They are forecast to top 10 per cent after the summer when a further £800 is added to the average annual bill by Ofgem.
Sunak effectively injected around £15bn into an already overheating UK economy last week. So, where does this leave the Bank of England?
Most of the present inflation spike is being driven by higher international energy prices. Central banks tend to ignore these types of supply-side shocks and hope they do not lead to strong upward wage pressures.
But, Stephen Millard, deputy director at NIESR, thinks Threadneedle Street has a level agency to tackle external price pressures.
“A central bank can deal with inflation caused by shocks that come from abroad. If you raise interest rates, you will appreciate the exchange rate and that will bear down on import prices,” he told City A.M.
Millard, who worked at the Bank for over 26 years, said leaving policy ultra-accommodative, when it should have been scaled back, has contributed to the current inflation jump.
“Monetary policy now has been so loose for such a long time, there was, if you like, incipient pressure for inflation to rise… as soon as you had that supply shock, we saw inflation go up in a way that maybe we wouldn’t have done had interest rates been at a more normal level.”
In response to the Covid-19 crisis in March 2020, governor Andrew Bailey and other rate setters slashed borrowing costs to a record low 0.1 per cent and kept them there until December 2021.
Around the middle of last year, price pressures were intensifying, leading experts – and even former Bank chief Lord Mervyn King recently – to criticise Threadneedle Street’s inertia.
It has since hiked rates to a 13-year high of one per cent, but economists think they will need to rise more.
To support lower rates, the Bank hoovered up hundreds of billions of pounds of government debt to offset volatility in financial markets caused by the pandemic, a process known as quantitative easing (QE).
“What [is] not clear [is] whether there was a need to maintain that level of QE once financial markets stabilised,” Millard said.
Critics of QE argue it can generate economic imbalances that fuel price rises.
Inflation taking off last year should have set “alarm bells ringing” for the Bank, Millard said, adding rate setters should have possibly started reversing QE and raised rates much earlier.
He argues the risk of a wage-price spiral occurring is strengthening now we are in the teeth of an inflation crisis.
“If wages rise, that is an extra rise in firms’ costs, which undoubtedly at least to some degree [will feed] into prices. If that starts happening as well, the idea that inflation of six, seven, eight per cent will sort of embed itself,” he said.
Price pressures are certainly skewed to the upside. China’s zero-Covid policy, the possibility of an EU ban on Russian gas and a new fiscal bazooka all point to inflation potentially climbing into the teens.
The dilemma facing the Bank is still plain, despite more government spending curbing recession risks.
Hike rates too fast, and it could deal unnecessary damage to the economy. But, do too little, and elevated inflation may be a longer fixture in the UK.
“To deal with inflation, you have to bear down even further on output” amid already cooling activity as a result of the supply shock, Millard said.
The Chancellor last week responded in a way governments should do to an inflation shock that is hurting the poorest.
The Bank may need to follow suit and consider a more restrictive tightening cycle.