Lord Griffiths: Can the Bank of England Stop the Drift of Inflation into Stagflation?

UK inflation is suddenly back with a vengeance. In an interview with the Financial Times, Huw Pill, the chief economist at the Bank of England (and my former colleague at Goldman Sachs) warns that the official rate of inflation may rise above five per cent early next year. This means that the retail price index could rise to seven or eight per cent.

For three decades we have lived with stable inflation averaging two per cent. This is the official government target set by the Treasury for the Bank of England. Along with financial stability, it is the Bank’s primary responsibility. For the first twelve months of the Covid lockdown, annual inflation was below one per cent. Last month it had reached just over three per cent on the official measure (five per cent on the retail price index). The UK is not alone. In Germany it was 4.1 per cent, the highest for 29 years. In the US it was 5.4 per cent. In fact, rising inflation has become a major challenge for all advanced economies.

The current global inflation is a classic case of “too much money chasing too few goods”. Lockdown led to a collapse in output and employment. In order to avoid a 1930s style Great Depression, deficit spending by governments of advanced economies rose to its highest recorded levels in peacetime. Central banks, including the Bank of England and the US Federal Reserve, cut interest rates to zero and whether intentionally or not expanded their balance sheets to finance the deficits (monetary financing). The result has been a massive fiscal stimulus and excessive money creation. At the same time supply chains have broken, shortages have appeared (petrol and building materials, for example) and energy prices have soared. In all advanced economies there is a general shortage of labour. In the UK following Brexit, migration has fallen dramatically and Boris Johnson has argued powerfully that he wishes to see the UK building on the success of Brexit by creating a “high wage, high skill, high productivity economy”. Unless productivity is raised, higher wages would lead to higher prices.

Meanwhile central banks have argued that the rise in inflation is “transitory”. As governments withdraw the budget stimulus and furlough subsidies, they expect inflation to return to two per cent. The working assumption has been that supply disruptions, such as the shortage of microchips, will continue but are being corrected and that because unionisation has been falling since the 1970s, the threat of wage push inflation is weak. Within this framework price expectations have not fundamentally changed: after this current blip inflation is expected to return to two per cent. Until now, central banks have consciously decided to take no action, either to cut back on money creation or to raise interest rates in order to deter spending.

In the last few weeks as summer turns to autumn and temperatures fall, central banks have begun to acknowledge that inflation may be more persistent and higher than previously thought. Even though the prospect of inflation had become a spectre on the horizon as far back as the summer of 2020, they have made no attempt to curb money growth or raise interest rates. 

This last weekend, Andrew Bailey, the Governor of the Bank of England, acknowledged that the Bank needs to act. “Monetary policy cannot solve supply side problems — but it will have to act and must do so if we see a risk particularly to medium-term inflation and to medium-term inflation expectations. And that’s why we at the Bank of England have signalled, and this is another such signal, that we will have to act. But, of course, that action comes in our monetary policy meetings”.

For central banks stagflation — the combination of rising prices, rising wages, low productivity, low growth and rising unemployment — has only been a distant dark cloud on the horizon. I wish to argue that stagflation is endemic to inflation, but that action by central banks and governments even at this late stage can avoid it. I am not suggesting a return to the 1970s, when inflation reached 28 per cent in 1974 and averaged 18 per cent over the four years 1974-77. Operational independence granted to the Bank of England in 1997 means that a return to the catastrophic inflation and stagflation of the 1970s is most unlikely. However, unless checked, we could experience unnecessary volatility in inflation with sudden spikes, jerky changes in interest rates, low productivity growth and high unemployment. 

There are a number of reasons why this could happen.


Expected inflation is no longer anchored at two per cent

First, medium-term price expectations are no longer anchored at two per cent. Actual inflation depends, in part, on what we expect it to be. If people expect inflation to rise to five per cent, businesses will want to raise prices by at least that number, workers and trade unions will wish to see wages rise by an equivalent number and landlords will push up rents by a similar amount. If inflation is anchored, an upward blip in the recorded rate will not lead people to change their behaviour and so a temporary increase is “transitory”.

When medium-term price expectations were anchored at two per cent no one was taking about the threat of inflation. Today everyone is talking about it. What will become of the triple lock for pensions and welfare payments, the cost of air fares for next summer’s holidays, the price of petrol at the pumps (now nearly higher than ever), rising gas bills, future interest rates and mortgage repayments?

Similarly, businesses face higher wage costs, higher input prices (tin, steel, wheat, oil and gas) and higher taxes (national insurance, corporation tax). They will wish to raise prices to preserve revenue and profit. Investors will keep trying to guess how and when central banks will change interest rates.

One reason central banks have not so far taken action is because inflation is in their judgement “transitory”. In reaching this conclusion they depend on their assessment of the “output gap” between existing output and full employment output. At a time when Brexit and Covid have created major structural changes in the economy, it is far from clear how much confidence we can place in measuring the “output gap”. Structural changes resulting from digitalisation, replacing “offshoring” with “reshoring”, the huge switch to investment in green energy from fossil fuels, the mismatch between jobs made redundant by Covid and the skills needed for new jobs created are making it unusually difficult to measure potential output.

For the Bank this is confirmed by consumer surveys, independent economic forecasts and implicit forecasts from financial markets, especially government debt markets. However, the last of these has much less reliability than it used to have, because of the extent of central bank intervention in markets. The most recent household survey by the Bank is for inflation of 2.4 per cent next year, falling to 1.9% after two years, which is what the Bank has been more or less telling markets to expect. Similarly forecasts from independent sources are just above two per cent. I believe it is difficult to attach too much weight to surveys, in view of their failure to anticipate what has actually happened this year.

The International Monetary Fund (IMF) in its recent annual report expects inflation to return to pre-pandemic levels, but even so the IMF qualifies its prediction by stating that “considerable uncertainty surrounds those forecasts particularly related to economic slack”, and that “any assessment of inflation anchoring cannot be decided entirely on the basis of relationships observed in historical data” as well as “when expectations become de-anchored, inflation can quickly take-off and be costly to rein back in”.


Trade unions ready to roar

The sharp rise in inflation, along with an unexpectedly rapid recovery of the economy, means that trade unions can once again create a wage-price spiral, adding a cost push factor to excess demand. 

The UK labour market is at its tightest for four decades. Current UK employment (29.2 million) and job vacancies (1.1 million) are at record levels, with staff shortages in pubs, restaurants, supermarkets and transport. The most recent figure for annual wage growth (which comes off a low base) was six per cent  and including bonuses was 7.2 per cent. Vacancies in road haulage drivers of up to 100,000 have been a focus of attention because of their role in breaking supply chains and creating shortages. Part of the problem is due to restrictions on immigration following Brexit, but what is extraordinary is that there are between 60,000 and 80,000 vacancies for lorry drivers in Germany and 400,000 across the EU. More generally there is a European-wide shortage of labour.

The three decades since the beginning of the 1990s and following the integration of China, Eastern Europe and India into the global market economy witnessed a massive increase of two billion workers into the world economy. The bargaining power of labour was weakened and trade union membership in private sector companies in major advanced economies fell dramatically. The contrast between the power of trade unions to push up wages in the UK in the 1970s and create a wage-price spiral and their inability to do so in recent decades could not have been more marked. Yet now the balance has altered again, this time in favour of organised labour. The newly acquired power of trade unions has been further strengthened by two further factors: the breakdown of globalisation due to the conflict between China and the US over trade and demographic forces, namely the fall in the dependancy ratio (the number of workers relative to dependents) and the growth in care for the aged.

For trade unions the ball is now at their feet. Because of an unexpected increase in inflation, most workers are facing cuts in the spending power of their wages. Some economists argue this is good, because supply shocks require workers to move into different jobs. This is done much more easily through cuts in real pay rather than by management having to lay off staff. But workers are not irrational. Neither do they suffer money illusion, any more than employers. Only last week strike threats over pay were announced by Scottish railway workers and refuse collectors during the coming Cop26 summit in Glasgow. Similar threats have been made by the largest UK trade union, Unite, on behalf of lorry drivers over relatively low pay, anti-social hours and poor driver facilities at service stations. The UK government is taking steps to address those problems. However, overall, the current red-hot state of the UK labour market suggests a wage-price spiral is a distinct possibility. 


Broken supply chains and shortages 

So far we have considered two reasons to be concerned that the current surge in inflation could produce stagflation. One is that price expectations are no longer anchored at two per cent. The other is that trade unions have become more powerful and could create a wage-price spiral. The third is the combined impact of Covid and Brexit in breaking supply chains and creating shortages.

Covid is not yet completely behind us and is still having a large and continuing impact on many aspects of our lives, forcing us to ask fundamental questions regarding purpose, lifestyle, location, compensation and time. Covid is the source of major structural changes in the economy, such as the extent and resilience of global supply chains (reshoring, offshoring, just-in-time), changed expectations in the labour market (working from home, working conditions generally), health risks (future pandemics), skills mismatches (higher wages), digitisation (shopping online) and online technologies.

One problem which was not foreseen initially was the massive impact which the scale of the initial monetary and fiscal stimulus, coupled with lockdown, would have on certain sectors of the economy. For example, when a large number of people decided that lockdown was the moment to improve their homes, suddenly there were shortages of timber, plywood, plasterboard, cement, insulation, adhesives and wheelbarrows, followed by rising prices. Broken supply chains and shortages, whether of petrol, building materials or toys and turkeys for Christmas are, for the foreseeable future, likely to be a continuing problem. Some are due to lockdowns followed by recoveries in different countries taking place suddenly and at different times and for varying duration. These are made worse in shipping by containers being in the “wrong” places, disruptions at ports and not enough lorry drivers to deliver goods. Brexit has definitely played a part in creating shortages, especially in the hospitality and transport sectors, but it is too easily overestimated as a major source of such problems. Felixstowe has a shortage of capacity as a port, but so do Rotterdam, Hamburg, Antwerp and, across the Atlantic, Los Angeles and Long Beach, the largest ports in the US. This is not just a UK problem.

The key conclusion is that we simply do not know how long supply restrictions will last and so lag behind increasing demand.


The Bank of England needs to act now

The rise of inflation over the past year, coupled with the Bank of England’s insistence that it is “transitory”, has left it open to the charge of complacency.

The present time is a great opportunity for the Bank of England to act decisively and bring inflation under control by anchoring it again at two per cent and ensuring the UK economy does not drift into stagnation. Three elements of this are important.

First, the Bank must take action now to end quantitative easing and raise interest rates. A start could be made with the Monetary Policy Committee meeting in November. Its members are best placed as to the way in which rates should be raised, whether by small amounts of one quarter of one per cent or by larger amounts, as well as the target level to which they should rise. I think they need to be raised at least to a level between 1.5 per cent and two per cent.

The one absolutely critical point is that interest rates must rise to a level which will reduce monetary growth and ensure that the public have confidence that the Bank is really committed to getting on top of inflation. After a time, inflation will then begin to fall. Central banks can only influence price expectations to a certain extent by making pronouncements. It is when inflation falls to its target and, through central banks’ actions, remains near target, that price expectations really take hold.

The danger we face is a reluctance by the Bank to take the tough steps necessary to achieve this. It will face criticism from people with variable rate mortgages and zombie firms which are no longer viable, as well as from economists who argue that higher interest rates will threaten to derail the recovery. Unless they are determined to bring inflation under control, however, they risk even higher interest rates later on. The key lesson of the post-war years in the UK and the US is that the longer central banks delay raising interest rates, the higher rates will ultimately have to rise and the greater the check to the recovery. 

Second, the Bank must communicate its medium-term policy in a way which is credible and coherent and must be committed to stick to it. This is not to suggest that it should follow a rigid monetary policy rule, but that it lays out its medium-term financial plan to avoid the “temper tantrums” experienced in the US when the Fed Governor Ben Bernanke embarked on his policy tightening in 2013.

Third, sound monetary policy must be backed by fiscal credibility. This requires the Chancellor of the Exchequer to lay out credible fiscal targets for the next few years, covering spending, taxation and borrowing. 

If the danger of UK inflation drifting into stagflation is to be averted, the Bank of England must act now; it must explain its policy in the medium term; and it must be supported by the Treasury’s fiscal policy.


This was first published in The Article.

Brian Griffiths (Color)

Lord Griffiths is the Chairman of CEME. For more information please click here.