Bank of England must walk a tightrope (or the plank)

3rd November 2021

A notable feature of last week’s Budget speech was that Chancellor of the Exchequer Rishi Sunak issued a reminder that setting interest rates is a task for the Bank of England. A previous Chancellor, Gordon Brown, had handed that responsibility to the BoE, whose Monetary Policy Committee meets regularly to review the BoE base rate, which influences rates elsewhere and can also impact the rate of inflation.

The point of the Chancellor’s reminder was that in setting interest rates the BoE must pay close regard to that impact on the inflation rate and try to keep annual price rises, as measured by the Consumer Prices Index compiled by the Office for National Statistics, somewhere around the official target level. That target has stood at 2% for some years, but the latest CPI rise in the year to September was 3.1%.

Inflation at 4 or 5 percent in prospect

In his Budget speech, the Chancellor also noted the Office for Budget Responsibility’s forecast of around 4% inflation in the coming year. The BoE’s new chief economist Huw Pill had days earlier hinted that a peak of 5% in the coming months would not be surprising. So, with the Chancellor at arm’s length from interest rate policy and the incoming BoE economics chief ringing warning bells on inflation, where does BoE policy stand now?

It’s probable that in normal times, with no COVID or Brexit effects in play, raising interest rates to curb demand in the economy would be the simple solution. Lifting interest rates would help to choke-off excess demand and perhaps over a period of months begin to stabilise prices. However, the price rises we’re all currently experiencing represent what you might call ‘the wrong kind of inflation’ for successful application of traditional policy responses.

Current price rises are driven largely by international and domestic supply chain pressures and by soaring global energy prices, which BoE interest rate rises would scarcely affect. Indeed, upping interest rates substantially could serve to exacerbate inflationary pressures by lifting mortgage rates and other costs that could feed into the cost of living, even prompting a 1970s-style wage-price spiral. So, a finely balanced judgment, like walking a tightrope, will be needed when the BoE makes its decision on rates this Thursday 4 November.

No quick fix from BoE on Thursday

Clearly, Huw Pill and others at the BoE recognise that their policy toolkit doesn’t contain a quick fix for rising inflation in its present form. Otherwise, instead of forecasting a possible 5% peak (some commentators think it could be even higher), Huw Pill would be saying that action by the BoE will rein in the price rises and return the CPI inflation rate to its target zone in the coming months.

There’s wide expectation that the BoE’s Monetary Policy Committee will indeed vote for a rate rise this week, if only to deflect suggestions of doing nothing rather than in expectation of a significant impact. So, borrowing rates for householders could rise, which will potentially moderate consumer desire to spend. However, it’s the supply side (oil and other cargoes delayed in the supply chain) that’s at the root of the problem.

Inflation isn’t all bad. Some economists say that a modest level of price rises reflects a healthy economy. It can even be good news for some, such as heavily indebted individuals and governments, whose debts shrink in real terms as each inflation-hit month passes. Governments can generally borrow at low interest rates, which may not be the case for individual unsecured borrowers, and if those rates are lower than the inflation rate then they’re gaining financially, in theory at least.

Everyone’s inflation rate is different

It’s ‘in theory’ because the CPI is based on a basket of items on which a fairly average UK consumer might spend their money. In reality, hardly anyone would have a spending pattern exactly as portrayed by the CPI; we all have our own uncalculated inflation index that reflects exactly how we spend our money, and that pattern may vary from year to year. There’s also house-price inflation, which may seem good to homeowners but not so good to prospective first-time buyers.

Whichever way you measure inflation, for those with money in the bank beyond what they need for immediate use plus provision for unforeseen expenditure, it’s an obvious enemy in times like these. With the CPI more than 3% above its level 12 months ago and interest on most bank deposits well below 1%, the spending power of money in the bank is being eroded. If the BoE orders a modest rise or two in rates over the coming months but inflation over the next 12 months turns out to be 4%-5%, the erosion over two years will have been considerable.


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