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
I commented in the introduction that the Bank of England has consistently failed to recognise the scale of the Inflation challenge. Each of their quarterly reports for the last 9 months has shown inflation higher than they expected and has deferred the predicted return to the target level of 2%. In February CPI inflation was 6.2% and they predicted a peak of 6.7% in March. In fact it reached 9% in April and they expect it to peak at 10% in Q4 2022. It’s also worth noting that the ‘old’ inflation measure of RPI was 13.1%. They currently predict inflation to fall sharply during 2023 and 2024 to be on target 2% by the end of 2024, failing below target in 2025.
Inflation is now at its highest since 1992, before the bank was given independence and given the task of using the lever of interest rates to keep inflation as close as possible to 2%. So recent and forecast inflation represents a massive miss for them. They have not been able to keep inflation anywhere near their target. They excuse themselves saying there is a difficult path to navigate between recession and inflation. But they also say they won’t hesitate to act to control inflation as that is their job. In reality they have hesitated!!
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%.
As a result, for the individuals involved to set a rate of 1% was a big decision and the idea that rates might need to move higher still is tough. So the three that wanted a 0.5% rise to 1.25% were outvoted. Commentators are currently forecasting that the base rate will rise to a peak of 2.5% towards the end of 2023. Personally, and I’m not an economist, just an informed business leader, I think the MPC will begin to panic (professionally of course) soon.
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.
In summary inflation will be ultimately controlled by falling confidence, unemployment reducing the demand for pay rises and a declining world economy. It will not be managed by interest rates. That is not a good short term outlook! (Although I remain optimistic over the medium term of 5-10 years – See the article on Creative Destruction!)Creative destruction article