London, (Parliament Politics Magazine) – The Bank of England (BoE) was remarkably slow in seeing an inflationary threat that was obvious to monetarists and businessmen. As recently as last May, the BoE was forecasting inflation rates between 1.9 per cent and 2.3 per cent in 2022, 2023 and 2024. It now expects inflation to hit 10 per cent before the end of the year. Despite its main job being to keep inflation at around two per cent, the BoE remains reluctant to raise interest rates in any meaningful way. The idea that interest rates of one per cent will address double digit inflation is laughable. The last time inflation was anywhere near the current level, the BoE interest rate was 15 per cent.
The Bank’s reluctance to go further is understandable. Raising interest rates is a bitter medicine at the best of times, there is no guarantee it will work, and it would make a recession, which is already likely, inevitable. Many people have forgotten what normal interest rates look like; they not exceeded one per cent since 2008. In a country awash with cheap credit, house prices rose to insane levels. If interest rates returned to their historic norm of 4-5 per cent, let alone 15 per cent, millions of people would struggle to pay their mortgage. Any increase would leave them with less money to spend, exacerbating the problems caused by higher prices.
I do not have a window into the BoE’s soul, but I suspect that their policy is to ride it out and hope for the best. If global energy prices settle down, if Russia withdraws from Ukraine and if farmers have a good harvest this year, we could be over the worst of it within a few months. But that requires a lot of things to go right. It also requires workers (and savers) to take a hit. The governor of the Bank of England, Andrew Bailey, said the quiet part out loud when he told employees not to ask for a pay rise this year. He meant it. If workers negotiate a 10 per cent pay rise, which would be a pay freeze in real terms, businesses will have to put up prices. If prices rise further, workers will demand an even bigger pay rise to keep their heads above water. This would create the kind of price-wage spiral we saw in the 1970s and create havoc.
The conventional wisdom for several decades has been that inflation cannot get out of hand in modern, globalised economies so long as trade unions are weak and there is a flow of immigrant workers. I am not so sure. Unemployment is at its lowest level since 1974 and many sectors are desperate for staff. Employees may find they have the upper hand in wage negotiations. That would be good for workers in the short term, but bad for the economy in the medium term. We therefore have an unsavoury choice between a sharp drop in real incomes or a period of stagflation that will require bitter medicine, such as a recession or high interest rates, to overcome.
Is there a better alternative to the devil and the deep blue sea? Probably not. The government could give people cash to ease the cost of living, but the sums required would be astronomical. It would have to borrow the money which, in practice, would be largely created by the BoE. Pouring yet more printed money onto an inflationary economy would be like pouring petrol onto a fire.
Alternatively, the government could cut some taxes, such as VAT, which would have the added benefit of promoting economic growth, but it would also require a vast amount of borrowing (unless the government makes large cuts to the public sector) and create similar problems to those outlined above.
In short, there is no solution. The best we can do is build an economy that raises productivity and creates growth so that we are better able to withstand the next economic shock. But that will take time. In the short term, there will be pain. Central banks have conjured up trillions of dollars in the last few years and we are now paying the price for indulging in fantasy economics.