Bank of England underestimated risk of inflation to stability | Gerard Lyon


The Bank of England misjudged the persistence of inflation. It also underestimates the risks its policies pose to financial stability.

The problems, however, do not end there. For much of the past decade, its low interest rate policies have contributed significantly to inequality, raising asset and house prices.

Furthermore, he has been too silent on one of the economy’s lingering challenges: namely, why do banks barely lend to small and medium-sized businesses? This problem, called the Macmillan Gap, was first identified in 1931 and the Bank, in 2019, recognized it to be a whopping £ 22 billion.

The immediate challenge for the Bank, however, is inflation. The annual rate of consumer price inflation (CPI) fell this year from 0.7% in January to 5.1% in November. It is expected to exceed the Bank’s 2% target throughout 2022, and as a result, a cost-of-living crisis will hit many people hard.

I expect inflation to peak at around 7% in April and remain high, before decelerating to 3% in early 2023. Notably, retail price inflation (RPI), which is used to determine many statutory prices, including rail fares and student loan payments, tend to be above the CPI and are currently 7.1%.

When the pandemic hit, the bank drastically cut rates to an all-time high of 0.1%. However, it has also embarked on large-scale money printing via quantitative easing (QE). He now owns £ 20bn in corporate bonds and an excessively £ 875bn in gilts, making him the biggest holder of government debt.

As the economy recovered this year, the Bank continued quantitative easing when it did not need it. And, as inflation rose, it could have raised rates, but didn’t. Then this month, as the economy faced an impending slowdown because of Omicron, it decided to raise interest rates from 0.1% to 0.25% and halt QE. .

Such a lack of judgment does not bode well for the future. With regard to inflation in particular, the question is, what “p” it will be: will it be transmitted, will it persist or will it be permanent? It doesn’t seem permanent, as the triggers are tied to temporary supply shocks due to the pandemic.

Wrongly though, the Bank believed that inflation would spill over quickly when it still looked likely to persist as companies raise prices to maintain margins in the face of rising costs and as it persists this drives expectations. inflation to rise and people to seek Better wages.

Sometimes the consensus is slow to respond to changes in the inflation climate. It happened in the early 1990s when we went from high inflation to low inflation. Likewise, in the 1970s, when the movement was from the bottom up.

Many might wonder why the Bank is raising rates when there is nothing it can do to control, say, rising energy prices. The challenge, however, are the second round effects. Hence the emphasis placed by the Bank on inflation expectations, which have risen, and on the tightening of the labor market.

Monetary conditions are also important. Surprisingly, despite this, the Bank’s Quarterly Monetary Policy Report never mentions the word money – suggesting that they are giving monetary conditions low priority.

Whether you are a monetarist or not, currency developments are a key indicator on the dashboard – a must to watch.

It’s not just about restoring monetary stability by curbing inflation, but the Bank’s actions also risk financial instability. The last time this happened was before the 2008 global financial crisis, so we should be concerned.

Low interest rates mean that financial markets do not properly assess risk. This encourages speculative behavior, which is exacerbated by the scale of QE. In addition, since the Bank is a non-commercial buyer, the magnitude of its purchases can distort the price of government bonds and therefore yields.

Basically, policy tightening is not just about raising rates, but also about what happens to the bank’s holding of bonds, as this impacts longer-term borrowing costs.

After 2008, monetary policy became the economic shock absorber. Today, monetary policy has shifted from recklessness to recklessness – and it will be a long and painful challenge to restore monetary and financial stability.

Given the vulnerability of the economy, the Bank needs a well communicated, timely, gradual and predictable exit strategy.

Dr Gerard Lyons is Chief Economic Strategist at Netwealth


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