Inflation, Bank of England and interest rates

Inflation is high and rising

Inflation is a problem. It ruins what could be good news with salaries up 7 per cent and unemployment down to 3.7%, the lowest since the mid 1970s in Q1

So why were they hesitant to act?  I think they struggled to accept the need to move interest rates in a way that hasn’t been done for at least 20 years. From 1970 until 2020 interest rates varied from 5% to 15%. They have been below 5% ever since. And even more dramatically they have been 0.5% or below since 2009 and for the last two years until the end of 2021, 0.1%.

This article is being published on the day of the June interest rate announcement when I expect they will begin to act more strongly and announce a 0.5% rise to 1.5% and the rate will soon rise to 3% or even 4% as the Bank tries… and fails… to control inflation. Again, in my not so humble opinion inflation will only come down when the supply chain price rises have worked through (which happens over a 12 month period) and the pain of recession has slowed pay rises. (Which I think will take longer – more on that in the linked article on employment).

So to explain my hawkish view further. I think the challenge we face is both because the bank has been too cautious and also because their sole lever, interest rates, is less effective than it was. It is fair to note the circumstances have been somewhat unusual; the war alone is expected to add 1% to inflation. The bigger challenge is, I think, more fundamental. The world has changed and the system hasn’t yet adapted. I am not sure the current approach of managing inflation through interest rates will survive.

Managing inflation will be difficult

In my not so humble opinion managing inflation is going to be much more difficult and painful than the Bank of England currently presents for a number of reasons:

• The bank has also been too slow to reverse Quantitative Easing (QE).
  – Colloquially known as printing money – this tactic was first used by the bank during the financial crisis, never reversed and then reinstated for the pandemic. QE must, according to economic theory, lead to inflation eventually unless it is reversed. Hopefully the Bank of England MPC will decide to start doing so today.

• The bank is mistaken in thinking inflation won’t be ‘sticky’.
  – Back in March I asked the deputy governor at one of their regular online briefings “What is it that causes inflation to take off and become persistent?” His answer was when people start to build inflation into their plans. eg Employers build into their plans price and wage rises and Employees start to expect inflationary pay rises. I thought “That’s just what I’m hearing from many MD2MD members”.
  – In May I asked “Why they don’t think we will face a wage rise spiral as we did in the seventies?” The answer was that the situation now is ‘quite different’. We no longer have powerful trade unions forcing through unaffordable rises. I thought “No but we do have a much more commercially astute labour force that understands their value and are prepared to negotiate and / or move if they aren’t paid the going rate” – I suspect the freer labour market is a tougher force for pay rises than the unions ever were.

• The interest rate lever has lost a lot of its power.
  – In 1992 when the current independent bank process was introduced, most mortgages were priced with a variable interest rate. A rate that varied in line with the base rate. That meant if the base rate went up, mortgage repayments went up immediately and hit people in their pockets so they had less to spend so price rises were difficult. Today only 25% of mortgages are variable rate. The impact of a base rate increase on mortgage repayments for the other 75% will be delayed, often for years.
  – And in today’s circumstances the causes of  inflation are largely global. There is a shortage of products and to a degree  people worldwide. Putting up UK interest rates will not change the shortages that are leading to price rises globally.