It was in the summer of 2021 that it first began to dawn on a small group of senior economists at the Bank of England (BoE) that they might have erred, badly. Not that they would ever put it that way. In the rarefied world of central banking one mostly talks in riddles and rarely admits a serious error. But that summer, still in the thick of Covid, it was fast transpiring that there could be a problem.
The first and second waves of the pandemic had crashed over the country, leaving the economy in what appeared an abject state. The government had showered Britain with furlough cash and the Bank had pumped billions of pounds into the monetary system via its quantitative easing (QE) programme.
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While a few people had voiced some fears about inflation – most notably the Bank’s departing chief economist, Andy Haldane – the Threadneedle Street machine had responded sniffily. The greatest risk from the pandemic, they argued, was that it would push prices down, not up.
Bank officials were worried about a depression. That was why they and fellow central banks around the world had restarted QE. Yes, there might be a little bump in prices as the lockdowns ended, but it was likely to be short-lived; “transitory” was the word of choice.
What, though, if they were wrong? What if inflation was not transitory but long-lived and sticky? That summer a few members of the Bank’s analytical team scanned the data and began to fret. Far from rising as expected, unemployment was staying stubbornly low. Wages were not falling and inflation, while still close to the Bank’s 2 per cent target, was beginning to build.
If the Bank had got it wrong, that could be disastrous. After all, it was still printing money and buying up government bonds via QE. Interest rates were at rock bottom. Inflation is, as some economists say, a monetary phenomenon and rarely had the monetary conditions been quite so stimulative. Inflation, classically defined, means too much money chasing too few goods. By printing money throughout the pandemic, the Bank, if it was wrong, would have been adding petrol to a bonfire. As the summer wore on there were some unnerving signs that this was precisely what was happening.
Monetary policy, which is what the Bank of England does, moves in slow-motion, like an oil tanker. A change in interest rates today might take 18 months or more to filter down into the system and begin to affect inflation. All of which is why it is worth pondering what was happening inside the Bank two years ago: like an oil tanker, the economy is slow to steer; its direction now reflects what the Bank was – or rather wasn’t – doing two summers ago.
We know what happened next. Inflation began climbing in the second half of 2021. By the end of the year it was more than 5 per cent and the Bank’s Monetary Policy Committee voted for the first of 13 interest rate increases (so far). The Bank was the first of the major central banks to raise the cost of borrowing; even so, it has failed to tame prices. Indeed, while the annual rate of consumer price index inflation has dropped from its high point of 11.1 per cent last October to 8.7 per cent in May this year, the cost of living in the UK is still rising faster than in any other G7 nation.
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So what went wrong? Did it come back to that error those Bank economists were beginning to fathom in the summer of 2021: the mistaking of inflation for deflation, and the shovelling of hundreds of billions of pounds into the economy? Did Brexit worsen Britain’s economic plight at the worst possible time? Or is there just something about this country that makes it particularly susceptible to inflation?
The answer, as is often the case in economics, is a bit of everything. In hindsight, the Bank did misjudge the nature of what we were facing. Perhaps these were understandable blunders, especially given the murkiness of data in the Covid period. But the end result was that the Bank was still pushing the accelerator even as it should have been easing off, or even tapping the brake.
But that was just the first of three problems. The second was to materialise in the following months as the Bank’s forecasting models kept underestimating inflation. Each new forecast predicted that price rises would pause and then tail off, but when the actual data came in those projections proved to be comically wrong. Eventually, the forecasts became so unreliable that members of the Monetary Policy Committee who set rates began to ignore them, a move that is almost sacrilegious in Threadneedle Street.
The Bank has now launched an external investigation into its models, though it is quite likely to find that it was simply making the same mistakes nearly every other forecaster was. There is groupthink within central banks and groupthink among central banks, and every other major counterpart to the BoE was making much the same noises.
But UK inflation remaining stubbornly higher than the developed-world average brings us to the third problem: that there might well be something about Britain that makes it especially susceptible to these spikes. This, after all, isn’t the first time we’ve been here. In the 1970s, UK inflation was mostly higher than in the rest of the industrialised world. When prices are swinging around the world, Britain often finds itself thrown about more than everyone else.
This is not to say that there aren’t some plausible explanations for why prices are rising so much faster in the UK than elsewhere. The most obvious is Brexit, which has added extra friction both to the labour and goods markets. Getting stuff into this country from Europe – speciality foods in particular – is taking longer and entails more paperwork. The flow of labour from the continent has dried up and while immigration numbers remain high, the figures have been swollen by those coming from Hong Kong and Ukraine, who are not all adding to the pool of willing workers.
Then there’s the legacy of austerity, still working its way through the labour market. There are two striking things about the industrial action in this country over the past year. The first is that there has been so much of it – more than in most European countries, across wider sections of both the public and private sectors. The second is that many of the wage negotiations seem to be just as concerned with clawing back the real income lost during austerity as they are with addressing losses caused by the present cost-of-living squeeze.
All of which might help explain the other data point haunting Britain’s economic policymakers: wage inflation well above 7 per cent – about a percentage point higher than the Bank’s internal estimates had expected. Then again, high inflation might reflect something else, too: it so happens that many people (mostly the better off) saved a significant amount of cash during the pandemic and are still in the process of spending it. In other words, they’re still very happy to pay for things – be they cucumbers or second-hand cars – even if prices are rocketing.
Either way, the country is now being forced to take its monetary medicine. The other defining feature of interest rates, beyond how slow they are to take effect, is that they hurt. They are designed to hurt, dampening activity, raising monthly debt repayments, and cutting real incomes, all in a bid to discourage people and businesses from spending. The less they spend, the lower the demand for goods and services, and the less retailers will feel able to charge. Inflation will thus eventually fall back towards target.
For many households this will be phenomenally painful, particularly for the cohort of thirty-somethings who have just got onto the housing ladder and extended themselves to the limit in so doing. Money markets are currently pricing in a peak of 6.25 per cent interest rates. While this is less than half the level that official interest rates hit in the late 1980s, when they precipitated a housing crash and a middle-class recession, this only tells you half the story. Adjust those interest rates for the fact that people are more indebted today, with lower incomes relative to their monthly payments, and the real impact for households with big mortgages will be as bad, if not worse.
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The pain will not be evenly shared. Older homeowners have now paid off their loans or have only nugatory monthly payments. Some will actually be better off, seeing higher returns on their savings and better annuity rates. If the defining feature of Covid and the energy-price crisis was a strange form of universality – that nearly all families were affected, and nearly all families had access to government support – this time will be different. There will be a deep inequality in the mortgage squeeze to come – just as austerity hit the poor far harder than it hit the rich, despite George Osborne’s claim that we were “all in it together”. (Indeed, the asset-owning class benefited greatly from earlier rounds of QE in the 2010s.)
Persistent inflation and higher interest rates will also have an uneven impact across the corporate world, where floating-rate loans are far more prevalent than in the mortgage market, and hence change instantly. In much the same way as there were malfunctions in the pensions system in October 2022 following Kwasi Kwarteng’s mini-Budget, higher interest rates tend to catch poorly managed companies off-guard. Thames Water is a perfect example: it was more over-leveraged than most of its counterparts, and more exposed to rising inflation via its index-linked bonds. It will not be the last example of a company suddenly facing potential collapse.
There is something else going on here. Part of the reason inflation was so low in recent decades was what economists call “secular” global shifts: China industrialising; businesses developing sophisticated just-in-time supply chains; an era of untrammelled globalisation. Developed countries outsourced much of their production overseas to save costs. The upshot was cheaper T-shirts, cheaper electronics, cheaper everthing.
But the US is now attempting to draw manufacturing back home via its Chips Act (for semiconductors) and the Inflation Reduction Act (for a host of green industries). Europe is pumping billions into its battery sector. The idea that you should simply buy technology from wherever is cheapest – which is, mostly, to say China – is fast losing credibility. It seems the tectonic shift that gave the world cheaper prices is now starting to reverse. We might be in a world of structurally higher inflation for some time.
And Britain, which deindustrialised faster than any other developed nation, outsourcing heavy industry and opting instead to import an ever increasing fraction of its goods from overseas, just so happens to be more exposed to these effects. If the world finds itself mired in a stickier, higher inflation rate for years, Britain might find it harder than any other country to bring prices back down, as has been the case so far.
The Bank’s view is that it will return inflation to its target. Even those who fretted in the summer of 2021 say they doubt that stopping QE, or even raising rates, back then would have made much difference. More to the point, they argue, the US Federal Reserve was still way behind the curve, and its actions have just as much, if not more, influence on UK inflation.
In Threadneedle Street they still insist that all inflation is tameable, in time. The only question is how much recessionary pain it will take to bring it down. Right now, the answer seems unnerving: a great deal more than the UK has already endured.
[See also: Is the Bank of England raising interest rates too far?]
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This article appears in the 05 Jul 2023 issue of the New Statesman, Broke Britannia