Why criticism of the Bank of England is largely misplaced

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The writer is a British economist at Morgan Stanley

With inflation higher than it has been in decades, there is no shortage of critics of the Bank of England. Yet most of the blame seems largely unfounded.

The BoE has been criticized for being too slow to raise rates and doing too little since. But the central bank had a particularly bad macroeconomic hand to play.

A previous, tighter policy regime would have had only a limited effect on mitigating current inflation, and under these circumstances BoE monetary policy might be the best choice among a tough set of options.

According to our forecast, the increase in food and energy bills will directly account for 60% of the inflation peak forecast in October. Non-core inflation is not something monetary policy can impact.

In December last year, the BoE pointed out that, given the lags in monetary policy, to deal with a build-up of imported inflation even before the Russian invasion of Ukraine, it should have started a fairly aggressive tightening policy as far as in the first wave of the pandemic at the start of 2020. This was just when the UK economy was about to be battered by a quarterly contraction of almost 20% due to first lockout.

Implementing such a tight policy might have contained inflation to the BoE’s desired target of 2% at the start of 2022, but unemployment would have increased by around 800,000 jobs, according to the modeling of the central banks.

In fact, relative to its peers, the BoE’s reaction has been quite timely. As early as last September, it recognized that inflationary pressures might not be transitory; and in February it raised rates twice and announced the start of its balance sheet reduction. In contrast, the Fed and the ECB were still buying assets as part of their QE programs.

Even the tightness of the UK labor market is probably more a story of supply than demand. Employment is still well below its pre-Covid peak of 210,000 jobs with labor supply falling by 290,000 workers as recently as May.

In addition to reduced migrant inflows, the lower national turnout is also a problem. For example, the UK has never had so many potential workers out of the labor market due to health issues. The BoE can impact labor demand by slowing growth, but it can do nothing to shorten NHS waiting lists.

Moreover, the relatively lackluster post-pandemic recovery in the UK belies the monetary policy-induced inflation argument. Growth in business investment has been very subdued and consumption growth is also slowing despite the simplistic reading of negative real rates of 8% after taking into account the inflation forecast for August.

Instead, it can be argued that a Brexit-related import diversion away from the EU is a possible culprit for the price spike. Inflation for manufactured goods in the UK reached its recent peak more than 4 percentage points higher than in the euro zone. Even the conventional view that higher rates alone can help support the currency, and therefore dampen inflation of imported goods, was quashed last week when the sterling dollar exchange rate fell to the following the BoE’s bold 0.50 percentage point hike as traders focused on the weakening. growth.

Faced with a more difficult employment/inflation trade-off than for other central banks, the action of the BoE was largely gradual in its approach in the first half of this year. Given that it projects a medium-term inflation rate well below 2%, there is an argument that the current Bank Rate Peg may already have reached the level consistent with the Bank’s mission. BoE to bring inflation down to 2% over time.

Yet, with high short-term inflation expectations and another imported inflationary shock on the horizon as gas and electricity prices are expected to rise again in October and January, the Monetary Policy Committee opted to a more forceful approach last Thursday. Raising rates by 0.50 percentage point while forecasting a prolonged recession demonstrates the intention of the MPCs to act against all inflationary pressures.

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So what about a possible fiscal policy? In our view, fiscal action should target low-income households, which have experienced relatively weaker wage growth so far and likely have little to no excess savings due to the pandemic. Such targeted support would protect the most vulnerable, while having a limited impact on inflation.

Alleviating labor shortages could also have the effect of reducing inflation, so supporting the NHS in reducing its waiting lists faster is a good option. The BoE has a tough job and no easy policy choices. Fiscal policy should not make the already difficult task of banks even more complicated.

The chart in this article has been modified to include the latest rate hike from the Bank of England

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