Threadneedle street’s calls for drastic measures risk over-tightening an already fragile economy
Andrew Bailey will not be able to dress up as a white knight in Threadneedle Street in the future, but he has been given the role in 2020.
The Bank of England Governor was thrust into the battle when the pandemic hit. He slashed interest rates, and pumped money out at an unprecedented pace through quantitative easing.
He followed in the footsteps of his predecessors, Lord King and Mark Carney who, by reducing borrowing costs to the bare minimum, had tried to protect the economy from the economic crises of the last 15 years.
The economy is now facing the opposite issue. As the Bank struggles to combat the inflation that has exploded, the Governor appears surprisingly ineffective.
Bailey has raised borrowing costs repeatedly, increasing the base rate in a desperate attempt to hold prices down.
Inflation has dropped to below 10pc only recently.
In April, it fell to 8.7pc. This is more than four-times the Bank’s target of 2pc and far above the rate at which the average worker sees their pay rise. Bailey, who chairs the Monetary Policy Committee, is expected to increase rates at Thursday’s meeting.
The committee’s ability is becoming increasingly doubtful. The confidence in our hero has waned, causing political concern and creating turmoil on the market.
Every time the Bank increases interest rates, and claims that it has done enough to reduce inflation in the near future, new data shows the economy’s other thoughts.
The markets are panicked at the thought of more rate increases. This will increase borrowing costs for Governments and mortgage holders , squeeze the economy , and put pressure on the Bank.
Last week, surprising strong data on the jobs market showed that private sector wages were soaring. Bailey acknowledged that it takes “a lot more time” for inflation to drop than expected.
The interest rates on government bonds soared, and many banks increased mortgage rates or reduced the number of loans that they offered.
The Bank of England base rate is expected to reach 5.75pc in the coming year. There’s a chance it could even reach 6pc, a level that hasn’t been seen for more than 20 years.
Senior city officials are concerned that the Bank has failed to control the turmoil. One prominent figure has asked the Governor to increase rates by 0.5 percent points this week in order to stay ahead of the market and show that the MPC controls the situation.
Few economists expected policymakers to be as bold.
Andrew Goodwin, Oxford Economics, says that “the recent market reaction indicates a lack of trust in the Bank of England’s ability to control inflation” and predicts a rise to 4,75pc next week.
He adds, “We believe the MPC wants to reassert their credibility in fighting inflation and will raise the Bank Rate again in August.
It is reasonable to exercise caution.
Ellie Henderson is an economist with Investec. She expects that most MPC members vote for a 0.25 percent increase, while only a handful of hawkish policymakers will opt for a bigger move to suppress inflation.
She says, “We believe the UK economy will be in recession by the end of this year.”
The Bank of England will have to tighten its screws in order to achieve this goal.
Huw Pill said that it was important to “strike a balance” between the need to return inflation to the target and the cost of the measures required to achieve this.
Swati Dhingra said last week that the rising cost of living “is already adding to the ongoing pressures on families who are renting or negotiating mortgages”.
It is important to understand the impact of previous rate increases on the economy.
In the past, policymakers believed that it took between 18-24 months for rate increases to be fully absorbed by the economy. This is because higher borrowing costs slowly reduce spending power of households and businesses, and thus flatten inflation.
The Bank has only been in reverse monetary policy for 18 months, and the majority of its effect on inflation is yet to be felt.
Raising rates now is not expected to have a significant impact on inflation until 2024, or even 2025. Even this old rule of thumb could be outdated.
Around half of all mortgages had fixed rates on the eve the financial crisis. The result was that half of the people with mortgages felt the impact of increased borrowing costs right away.
For a while, the majority of mortgage borrowers will not be affected by the higher costs. Bailey’s task is made more difficult by this.
The Bank may increase rates and see little impact, then raise them again. Only to discover that the cumulative effect is much stronger and later than expected.
The officials are in a difficult position as they face intense pressure from the markets and politicians who react to every new set of data, such as May’s figures for inflation which will be released on Wednesday. It is expected that this reading will exceed 8pc.
Jagjit Chadha is the director of the National Institute of Economic and Social Research. He says that the Bank already has done enough to bring inflation under control before 2025. It would not have been forced to do more if the Bank had convinced the markets of this.
He says that if we are not clear in our communication, we may have to increase interest rates more than we would have otherwise. Then we will have to turn around the recession.
Sven Jari Stehn, Goldman Sachs, does not expect that the Bank will discover this confidence in the next week.
“We look for a continued pattern where the MPC remains non-committal on further tightening but is then pushed into more 0.25 percentage point hikes by stronger-than-expected data,” he says.
The data is still a bit surprising, especially given the remarkable resilience of the job market.
Megan Greene told the MPs that it was crucial to eradicate inflation in its entirety.
You cannot allow inflation expectations to be de-anchored or you will end up in this situation. She said that the 1980s and 1970s are the best time to learn from.
The Bank is balancing the risks of a recession.
There is always the risk of overtightening. Greene explained that central banks must determine whether this is the biggest risk or not tightening further.
Capital Economics’ Paul Dales argues that the Bank should focus on squashing the inflation, even if this leads to a downturn – as he believes will happen.
“We’ve effectively gotten through the cost-of-living crisis without a depression, which is quite remarkable,” Dale says.
“But I do not think that we will be able to avoid a recession without the cost of borrowing crisis.” Avoiding one would be pretty good, but avoiding two would require a miracle.
The Governor may not be able to win this battle, whether he is wearing armour or not.