Sunday, November 21, 2021
The Bank may simply be a bystander as inflation rips
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.

What a difference a month makes. Four weeks ago, when official figures showed a drop on consumer price inflation from 3.2 to 3.1 per cent, there was quite a lot of scoffing directed at the inflation warriors. That temporary fall was, though, an aberration. The jump in inflation to 4.2 per cent last month, announced a few days ago, was more reflective of the story.

Inflation is going up, and the warriors were spoiled for choice in the latest figures. Retail price inflation rose to 6 per cent, its highest for 30 years. Factory-gate inflation, measuring industry’s output prices, rose to 8 per cent which, like consumer price inflation, was the highest for 10 years. And, for good measure, the official house-price index showed an annual increase of 11.8 per cent.

When these figures were released, I wondered what the market reaction would have been if the Bank of England had raised interest rates on November 4, as the City expected it to do. Would markets have judged that the Bank was right to act ahead of a bad set of inflation figures? Or would the reaction have been much the same as it was, in other words that the Bank is under pressure to raise rates next month, breaking a December duck that has survived nearly a quarter of a century of independence? Even the Bank does not want to be portrayed as the Grinch that stole Christmas.

The point is that when inflation is rising markets are unlikely to be satisfied unless interest rates are raised every time the central bank remains a decision. Had rates been increased in November, the markets would have been looking for another increase next month, and in February. By not raising rates this month, the Bank delayed that lift-off.

There is another question I wanted to address this week, however, and it is whether faith in central banks, and their ability to control inflation, is misplaced. A 0.1 per cent Bank Rate looks inappropriate when set alongside inflation of more than double the official target and heading to 5 per cent or more. But would a 0.75 per cent rate, which is where it may be heading in coming months, be any more appropriate? When inflation was 5 per cent in the period before the financial crisis, back in the early 1990s, typical levels for official interest rates were 5, 6, 7 or 8 per cent.

The subversive thought I have is that central banks like the Bank, far from being the masters of the universe, the controllers of inflation, are mere bystanders in the process. The fact that they have presided over generally low inflation over the past three decades is good news for them, because that is what they are supposed to achieve, But it may just be a happy accident.

Consider the last time consumer price inflation was as high as now, eventually topping 5 per cent 10 years ago in 2011. What did the Bank do to bring it down?

The answer is absolutely nothing. Bank Rate, which had been 0.5 per cent since March 2009, stayed at that level until August 2016. The Bank “looked through” the rise in inflation by looking away. Inflation’s fall, which was not complete until the end of 2013, when it came down to the target rate of 2 per cent, happened of its own accord.

There were, to be fair, some votes for higher interest rates on the Bank’s monetary policy committee (MPC) during this period, and it is possible that these led the markets to do some of tis work for it by tightening monetary conditions.
Inflation came down, however, because of factors outside the Bank’s control; a fall in world oil prices and the chilling effect of the eurozone crisis on the UK’s economic growth.

Today we stand at another inflation crossroads. The most likely outcome is that the 2011-13 story repeats itself. Some of the factors pushing inflation higher now are clearly temporary. A 27.4 per cent increase in second-hand car prices between April and October reflects the limited availability of new cars as a result of chip shortages and is highly unusual.

The increases in household electricity and gas prices over the past 12 months, 18.8 and 28.1 per cent respectively, are the biggest for 13 years. There is more to come on household energy, next spring, but you would not expect increases of this size to become the norm in future years.

There is a reason why inflation should come down even if prices stay high, which sometimes passes people buy. It is quite possible that we have moved to new higher levels of energy prices, and that petrol and diesel at close to 150p a litre becomes the new norm. But there is a difference between higher price levels and higher inflation. Only if the components of the consumer prices index rise at a faster rate than now will inflation go on rising beyond next spring.

Inflation will not come back down as quickly as the Bank first hoped. Its latest projections suggest we will not see a return to the 2 per cent target until the spring of 2024, in two and a half years’ time.

But when it does come down, and after the Bank has raised rates only modestly, perhaps to only 0.75 per cent (the rate prevailing before the pandemic) or 1 per cent over the next 12 months, it will pat itself on the back for not having been panicked into bigger rate rises. The fall in inflation, though, will have been mainly due to factors outside its control; international energy prices and the shortages resulting from the rapid reopening of the world economy easing.

To be fair to the Bank, it would argue that the monetary game has changed since before the financial crisis. The “neutral” level of interest rates is much lower than it was, implying that small changes in rates at these very low levels can have big effects. It may be, though, that these small changes do not have much effect, and that inflation largely comes down of its own accord.

There is another possibility in all this, of course, which is that inflation becomes more ingrained and that 4.2 per cent is just the taste of things to come. In the past, the combination of labour shortages and falling real wages – which most people will experience in coming months – would have been enough to generate big pay increases.

That was part of the alternative scenario sketched out by the Office for Budget Responsibility (OBR) in its budget assessment on October 27, and which had the Bank being forced to hike interest rates to 3.5 per cent. The Bank does not want that to happen, and neither does the Treasury, worried as it is about the debt interest bill. Neither will many borrowers.

The Bank favours a softly-softly approach on rates. Just let us not give it too much of the credit if and when inflation comes back down again.