Sunday, October 31, 2021
A scary Halloween story on inflation and interest rates
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

Amid the avalanche of information we get at times like this, which nobody normal can possibly make sense of, let alone the MPs patiently sitting through Rishi Sunak’s slightly surreal budget speech a few days ago, one thing jumped out at me. As the Bank of England contemplates what to do this week – amid frenzied speculation about an imminent rise in interest rates, either this week or next month – it concerned inflation, the issue of the moment.

It was from the Office for Budget Responsibility (OBR), the official forecaster. People of a nervous disposition may wish to look away now. Even on Halloween it is a bit scary.

The OBR set out what is its central forecast for inflation, which has it rising to 4.4 per cent by the spring of next year, and averages 4 per cent for the year. It then comes down, though it is not predicted to get down to the 2 per cent official target, as an annual average, until 2025. Retail price inflation, important for the public finances, student loans and many people, is forecast to rise to 5.4 per cent in January.

On this, its central forecast, the Bank raises official interest rates to 0.75 per cent very soon – a nudge to the Bank – and they stay there. The rise in inflation will be uncomfortable, and it will mean that real wages (earnings adjusted for inflation) barely rise over the next three years.

That high-wage economy the government keeps talking about is a distant prospect. But the rise in interest rates foreseen by the official forecaster would keep the cost of borrowing within the bounds it has been in since the financial crisis. Bank rate has not been above 1 per cent since early 2009, and a steady 0.75 per cent would maintain that and should not unduly frighten the horses, or anybody else.

It is the alternative scenario, or scenarios, set out by the OBR that would indeed frighten the horses and be a profound shock for the economy and for every business and household that has come to regard the ultra-low interest rates of the past 12-13 years as the norm. The OBR looked at two sets of circumstances in which inflation would be significantly higher than in its central forecast.

One was if prices, particularly but not exclusively energy prices, rise more than it currently expects, as businesses increase margins and seek to recover their higher costs. The other is if higher wages result in powerful echo the wage-price spirals of the past. The two have different implications for the economy. In the first, higher prices without a compensating increase in wages intensifies the squeeze on real earnings, leading to a big fall.

The two add up to the same broad message for inflation, however, which is that it would go up a lot, and the Bank would be required to respond aggressively. Inflation would rise to 5.4 per cent and still be 4 per cent in 2023 and 3 per cent in 2024. Based on what the OBR describes as “a simple monetary policy rule” the Bank would have to put up interest rates to 3.5 per cent.

You may say that inflation of 5 per cent or so is not terrible, so the Bank could afford to “look through” the rise, as it has done before. But the official forecaster estimates that without a response by the Bank, the inflation peak would be two or three percentage points higher, so 7.5 or 8.5 per cent. What it describes a “vigorous monetary tightening” would prevent prices at the end of the forecast period being 8 per cent higher than otherwise.

This is not, it should be said, a bunch of economists in Whitehall opining on inflation and monetary policy. This aspect of the OBR’s assessment was overseen, in his final forecast exercise as a public servant, by Sir Charlie Bean. He was chief economist and deputy governor at the Bank, attending 166 meetings of its monetary policy committee (MPC) from 2000 to 2014, so he knows a lot about setting interest rates.

I suggested this was not for the squeamish, and that has to be right. A Bank rate of 3.5 per cent before the financial crisis was unremarkable. When it happened in 2003, for a few months, it was the lowest official interest rate in more than half a century. Such a rate now would, however, crash the housing market and, most likely, push the economy into recession. We have been flirting with mild stagflation for some months. This would be the real thing.

It may not happen, and we have to hope it does not, though some reading this are no doubt yearning for significantly higher rates. But to the cocktail of factors pushing up inflation, which include a 0.1 per cent Bank rate, £450 billion of quantitative easing, the effects of global opening-up on energy and other prices, we have to add the budget. Was it wise at this juncture to unveil a post-pandemic splurge in public spending and highlight measures like a 6.6 per cent increase in the national living wage?

The chancellor, of course, took advantage of lower borrowing forecasts from the OBR. In some ways we have returned to the fiscal picture first envisaged by the official forecaster when the coronavirus pandemic first began last year. This was that there would be a short, sharp shock to the public finances, followed by a fairly rapid return to normal. That return to something like normality for the public finances, though public borrowing will still be £83 billion in 2022-23 and £62 billion in 2023-24, after £183 billion this year, prompted the relaxation.

As for the growth outlook, we should not get too excited by that. The new forecast for this year, 6.5 per cent, up from 4 per cent, is largely a reflection of the fact that the OBR expected the economy to shrink more in the first quarter, during the third lockdown, than it did. Its forecast for next year, 6 per cent, is actually lower than the 7.3 per cent in predicted in March.

Growth will soon slow to normal and rather disappointing quarterly rates. The OBR expects a gradual improvement in productivity growth, though only to 1.3 per cent a year, below the long-run average of 2 per cent. It has made such predictions before and the outcome has disappointed.

The chancellor was dealt a tough hand when he took over as the pandemic was breaking. He has dealt well with the challenges. But this is not an outlook which meets his description of “an economy fit for a new age of optimism”.