UK inflation is at a 40-year high and rising. The consumer price index has hit 9%, the retail price index 11.1%. As the Government’s official target is 2%, the blame game is in full swing, with the main target being Bank of England and its Governor, Andrew Bailey.
The Government’s priorities, outlined in the recent Queen’s Speech, are “strengthening growth and easing the cost of living”. That is something we can all agree with. It means better housing, better public services, making a reality — not simply an aspiration — of levelling up, reducing inflation and helping those squeezed by the rising cost of living.
If these objectives are to be realised, one requirement has to be met.
Inflation must be brought back down to 2%, the Government must endorse 2% as the target going forward and, most importantly, it must be delivered. This cannot happen immediately, but the Bank states in its recent Monetary Policy Report that it can be achieved by 2024.
The rising cost of living is now the number one challenge facing the Government. It is proving painful for most people, but extremely painful for the least well off. We have all heard or read stories of so many families who are desperately trying to help their children and themselves just to bring food to the table. Fuel poverty has already hit 20% of households and is predicted to rise to 40%.
Inflation is clearly painful, but it is more than just a painful economic shock.
Inflation is a corrosive force in our society. It creates suspicion, distrust and social conflict. It produces a blame culture, which undermines trust. People think the local corner shop is just jacking up prices to do them down, just like the large electricity companies. The same applies to Shell and BP who have done nothing special to earn the massive rise in profits. Supermarkets are no different. Why is Waitrose increasing prices much more than Aldi and Lidl? Inflation breeds a culture of blame, resentment and distrust. The threatened strike by RMT, the rail union, later this summer, could well become a landmark for higher wage settlements and a signal that stagflation may not be a temporary phenomenon.
The prospect of a windfall tax on the excess profits, not just of gas and oil producers but electricity generators, including wind farms operators, has needlessly infuriated these companies. This creates uncertainty, hits business confidence and will raise the cost of capital for investors. Multinational companies may well prefer to invest elsewhere.
Tackling inflation is where the Bank of England comes into the picture.
When the Covid pandemic hit the UK at the start of 2020, nearly everyone was supportive of the Bank of England slashing interest rates to 0.1%, increasing monetary growth and supporting businesses with easy credit. The objective was to avoid another Great Depression like that of the 1930s: falling prices, mass unemployment and business failures. I supported the Bank pursuing this objective, not least by increasing money supply growth to finance increased spending on the NHS, the furlough employment scheme and providing more credit at cheap rates for businesses.
However, already by the late summer of 2020 there were signs that the policy was giving a lift to the economy: company sales were rising briskly, corporate profits increasing and prices in assets which were hedges against inflation taking off, such as gold and precious metals, commodities, o bjet s d’arts , even Michael Jordan’s basketball shoes.
Back in August 2020, I wrote an article , “The spectre of inflation”, which argued that we were in danger of creating too much money for the supply of goods and services available. I followed it up last year with four more articles for TheArticle, criticising the Bank for not raising interest rates and urging action.
Unfortunately, last year the Bank made a serious policy error which consisted of keeping interest rates very low and through Quantitative Easing buying government stock in the market and increasing money growth, while insisting that inflation was “transitory”.
With inflation now at 9%, the Bank of England and the Governor, Andrew Bailey, have taken a hammering from backbench MPs, in the House of Lords debate and from numerous commentators. Frankly, I have been surprised at the ferocity of the attacks in the middle of a debate in the Lords and changed the content of my speech there because I felt that we were beginning to play the man (Bailey) and the institution (the Bank), not the ball.
In the Bank’s defence
To start with I do not believe that the Bank or the Governor were “asleep at the wheel”.
The pandemic was an extraordinary event with a series of new variants of the Covid virus, a series of lockdowns and genuine uncertainty as to how exactly the economy was behaving. The fall in output was the worst recorded in 300 years. The lockdowns were more severe than during any of the wars in our history. Next, there was considerable uncertainty over the extent of the true measure of unemployment, as it was disguised by the furlough scheme. As is clear from the evidence given by members of the Monetary Policy Committee to the Treasury Select Committee (9 May 2022), their so-called “dithering” over whether to raise interest rates in November 2021 was simply their collective caution because the furlough scheme had only come to an end the previous month.
Meanwhile throughout the whole of this 18-month period, other central banks, such as the US Federal Reserve and the European Central Bank, were (like the Bank of England) convinced that the increase in inflation was “transitory” and would of itself come down soon. They were advancing similar arguments to the Bank of England. Some allowance should also be made for the fact that hardly anyone on the Bank’s staff had lived through the inflation of the 1970s.
The one criticism therefore that does not hold any water is that they were “asleep at the wheel”.
In addition, for most of the period up to November 2021 most commentators had not been calling for the Bank to raise interest rates. They were very happy with forecasts which showed a remarkable economic recovery and their major concern was that they did not wish to see it jeopardised by higher interest rates. The outcome they feared most was not inflation but recession.
The Bank’s defence of its policies was weakened by three other factors.
First, there has been a lack of intellectual diversity among members of the Monetary Policy Committee. With rare exceptions they have all accepted the New Keynesian framework in which policy has been conducted. This has resulted in underestimating the genuine uncertainty facing policymakers in the world in which we live. They have highly emphasised the importance of the expectations of inflation held by consumers, businesses and investors, but have misled themselves into believing that by issuing “forward guidance” about what is really taking place in the economy and through the powerful toolkit at their disposal (changing interest rates and buying and selling government stock), they could thereby control inflation.
Second, there has been groupthink among central banks. They meet monthly at the Bank for International Settlements in Basel and in any case can talk to each other at any time. The result has been that all of the leading central banks employ the same intellectual framework.
Third, the Bank of England has as its primary goal the control of inflation. However, it has numerous other secondary objectives: stability of the financial system, support for the government of the day’s economic policy, specifically growth and employment, the soundness of firms, ensuring competitive markets in the financial sector and most recently the resilience of the financial system to reach to net zero. Certain of these objectives clash with each other and so the Bank has to make a judgement on trade-offs. The result is that instead of always looking ahead, it has to look sideways to find out the public’s likely response to such things as higher mortgage rates, a slowing growth rate, rising unemployment, or progress towards net zero.
Neglect of money
The major failure of the Bank, however, is none of these but an intellectual error, namely the neglect of money growth as one key determinant of inflation. Far from being asleep at the wheel, those in the driving seat have 100% focused on the journey, the vehicle has been in fine condition, all the controls have been working well, but they have been using the wrong map and handbook.
The importance of money growth in understanding any sustained bout of inflation is in my judgement beyond dispute. Even those who recognise the importance of money (“monetarists”) recognise its limitations. For example, Milton Friedman wrote:
“The proposition that inflation is a monetary phenomenon is important yet it is only the beginning of an answer to the causes of and cures of inflation… because the deeper question is why excessive monetary growth occurs”. (Milton and Rose Friedman, Free to Choose p. 264, Secker & Warburg 1980, London)
In a similar vein, Friedrich Hayek argued: “I will admit that in its classic form, as now revived by my friend, Milton Friedman, this theory [monetarism] grossly oversimplifies things by making it all an issue of statistical aggregates and averages.” (Commentary, the Times, 28 March 1980)
This is particularly true at present when there is such uncertainty over the likely course of policy making and shortages, sanctions and tight labour markets all of which affect aggregate output.
There is also one further but important conversation.
The Bank of England was established over 300 years ago and has served us well. It has avoided hyper-inflation during times of war, unlike many other European countries and until it was nationalised in 1946 the Bank was entirely independent of government. It was only 25 years ago that it was given back operational independence. It is a venerable institution and one of the pillars of our unwritten constitution. As Lord Fox, the Liberal Democrat peer, said in a recent debate in the House of Lords: “We have to be careful not to undermine — or to set in train a process that undermines [an independent Bank of England]. We… have a duty of care around this issue.” (Hansard Vol 822 No 4, 16 May 2022.)
The current lapse in performance by the Bank is no reason for the Treasury to take back control. It is they, after all, who have appointed members of the Monetary Policy Committee.
When in the 1970s the Bank increased money growth to finance the Barber Boom and facilitate our entry into the European Economic Community, the blame for the inflation lay solely with politicians. The Chancellor was the key person responsible for setting the level of Bank rate and effectively the conduct of monetary policy. Today it is not the politicians who are first in the firing line, but the Governor of the Bank of England and the Bank itself.
While no individual or institution is beyond criticism, because of the Bank’s standing in our unwritten constitution and the status of its staff as unelected public servants who cannot say everything they might wish to, we do have a duty of care.
In my judgement the tone recently has become uncomfortable. Instead, the focus of comment should be on three issues.
1. We should be strengthening the resolve of the Bank to act now to raise interest rates. At present the real rate of interest (i.e. Bank rate adjusted for inflation) stands at negative 8%: this has put us on the road to stagflation along which we are travelling. A rise in rates to whatever level is necessary will change people’s expectations of inflation.
2. Everyone would like to avoid a recession. The best way to limit the impact of a recession is by rising rates now to whatever level is necessary, so that people become convinced that inflation will be brought under control.
3. The fiscal boost to household spending just announced by the Chancellor, coupled with a very tight labour market, is a window of opportunity for the Bank to act.
This article was first published in TheArticle.
Lord Griffiths is the Chairman of CEME. For more information please click here.