Thursday, March 23

Taming runaway inflation may force the Bank of England to crash the economy

In the US, the Federal Reserve raised rates by 0.5pc to 1pc on Wednesday. Markets are pricing in further rises of more than 2 percentage points this year and further rises next year too.

But while the Fed has shown that it can at least taper quantitative easing and raise rates when necessary (albeit very slowly and not to “normal” levels), the Bank of England has yet to pass the same test.

The Fed, after all, has been through the “taper tantrum” of 2013, when then-chair Ben Bernanke warned markets it would at some point start reducing its quantitative easing program and sparked a huge sell-off in Treasuries and emerging market assets. After some delay, the Fed did indeed taper and raise rates.

The Bank of England, worried about Brexit over the same period, never really moved rates off the floor at all. And while the Fed has now announced a plan to wind down QE – and at a faster rate than in 2014-15 – the Bank has yet to do anything of the kind, despite having a balance sheet that is now worth nearly half of Britain’s GDP .

Already, last summer, the Bank’s lethargy had begun to attract significant criticism.

A report by the House of Lords’ Economic Affairs Committee (including one ex-governor Mervyn King in its membership) concluded over the course of 68 politely worded pages that the Bank does not know what the effect of QE has been, cannot say whether it has helped to achieve its mandate, won’t discuss how and when it will wind it up, produces research that is markedly more positive about QE than independent work and was “defensive” about discussing its malignant effects.

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With another supply chain crunch in the works as China turns large parts of its economy off and on, the effect of the great QE hangover on prices is only going to get worse, yet none of these issues have been addressed since the report came out.

Instead, the Bank’s mandate, which is nominally just to keep inflation to 2pc, seems to get more complicated every year. The latest task handed over by the Treasury in recent years was to work out how to force financial markets to go green, helping to raise the cost of capital for fossil fuel investments, a project which is likely to raise costs for consumers even further.

This comes on top of the duty created after 2008 to maintain financial stability, in the name of which the Bank directly intervenes in all sorts of decisions private banks used to make, like how to assess the riskiness of their customers.

In this vein, in 2014 the Bank started telling mortgage lenders that they had to check whether aspiring homebuyers would still be able to afford their mortgage payments if bank interest rates rose by 3 percentage points. This, as you’ll note, is only a little more than the amount by which markets expect rates to rise.

Inside the government, as the Prime Minister indicated during a television interview this week when he said that benefits could not rise because of the risk of stoking inflation and interest rate rises, there is visceral fear at the prospect of mortgage payments shooting up.

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Not only would it slow down the whole economy, as the households with the most savings see their biggest cost rise. It would particularly hit those most likely to vote Tory.

So I am sure it is a complete coincidence that a few months ago the Bank of England announced a plan to consult on scrapping the 3pc stress test requirement for mortgage lenders. An announcement loosening the rules is expected this week, just as interest rates are meant to rise.

In other words, the Bank might be taking a monetary slack with one hand, but it’s letting it out with the other. It’s doing so at a time when house prices have risen 10pc in one year, at a pace last seen in 2007.

Meanwhile, there is the gilt market to consider. The Office for Budget Responsibility pointed out last year that one perverse effect of QE is to make the public finances much more exposed to rising interest rates, meaning that for every 1 percentage point rise in rates, debt interest payments go up by £20.8bn, or 0.8pc of GDP.

There’s also the question of who is going to buy all these gilts if the Bank starts selling them, and what that means for fiscal policy. As last year’s Lords report noted, markets widely interpreted the vast, post-Covid expansion of QE almost explicitly as a move aimed at financing the government’s enormous fiscal stimulus – which would go directly against the Bank’s mandate if it were true. The Bank naturally denies this.

I am not suggesting the existence of some dastardly conspiracy between politicians and economists to ignore inflation. But the more you look, the more apparent it becomes that the Bank has wandered deep into awkward political territory.

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Its mandate to control inflation may well require it to trigger a recession by sharply tightening monetary policy. But all sorts of other priorities are pushing in the other direction.

Is it any wonder if policymakers are still clinging hopefully to the idea that inflation is just going to go away without too much painful action on their part? Isn’t it curious, though? This is precisely the phenomenon that central bank independence was designed to avoid.

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