Inflation Alert: How the Bank of England’s Loss of Control Spells Trouble for Everyone

Unraveling Inflation Woes: A Challenging Battle for Central Banks

Introduction:

Last week’s inflation figures left many experts disappointed. Despite a drop in the headline rate from 10.1% to 8.7%, the underlying core inflation rate, which excludes food prices, rose from 6.2% to 6.8%. The situation has prompted concerns about the effectiveness of central banks’ policies and their ability to control inflationary pressures. In this blog post, we delve into the causes of this inflationary surge, analyze the failures in forecasting and policy, and explore the potential consequences of a prolonged battle against rising prices.

Inflation: Beyond Transitory Factors:

Both the Bank of England and the US Federal Reserve initially dismissed the upward pressure on prices as transitory. However, they failed to acknowledge the potential lasting effects of transitory increases on wages and prices. History has shown that temporary cost surges, such as the oil price spikes in the 1970s, can lead to persistent inflation. It is evident that central banks overlooked the importance of monitoring the money supply and placed excessive emphasis on inflation expectations.

Neglecting the Money Supply:

One of the key issues highlighted by critics, including myself, is the apparent neglect of the money supply by central banks. This oversight in analyzing the growth of money circulating in the economy has contributed to the miscalculation of inflationary pressures. Additionally, an excessive focus on inflation expectations, assuming that individuals and businesses predominantly base their behavior on future speculation, further compromised accurate forecasting.

Living through a Wage-Price Spiral:

The current wage-price spiral has been primarily fueled by the significant increase in costs, leading to a squeeze on living standards. This phenomenon occurs amidst a tight labor market due to various factors limiting the available workforce, coupled with loose fiscal and accommodative monetary policies. The failure to anticipate these developments has resulted in misguided policy decisions by central banks.

Policy Failures: A Lack of Boldness:

Central banks not only failed to raise interest rates promptly but also demonstrated a lack of boldness in their actions. Modest interest rate hikes, such as the contemplation of a 0.5% increase rather than the usual 0.25%, fall short of addressing the severity of the inflationary challenge. By contrast, historical examples of combating inflation show that more decisive action, like the substantial rate increases in the past, can be necessary to regain control.

The Risk of Monetary Tightening:

Bold moves in monetary policy always come with risks, particularly in the current economic climate. The ideal approach would be to tackle inflation without hampering economic growth, employment, or risking a financial crisis. However, this approach may be too optimistic. Once inflation gains momentum, it becomes increasingly challenging to rein it in. The process of rectifying the situation is likely to involve significant pain and potential adverse consequences.

Looking Ahead: Balancing Inflation and Growth:

In the coming months, the headline inflation rate may decline as the monthly increases from the previous year fall out of the annual comparison. Additionally, the rate of increase in producer prices has started to ease. However, the source of the inflationary problem has shifted from the prices of goods to the rise in unit labor costs, especially in the service sector. To maintain inflation at 2%, productivity growth must improve, and average earnings growth should not exceed 3% compared to the current 6%.

Unveiling the Need for Higher Interest Rates:

For some time now, I have advocated for interest rates to reach around 5%. However, recent market expectations have surpassed this, with a projected increase to 5.5%. It is now increasingly probable that rates will need to rise to 6% or possibly even 7% to effectively combat inflation. Such a scenario would not only impact mortgage holders but could also dampen economic activity.

Conclusion:

The recent inflation figures have exposed significant challenges for central banks in combating rising prices. The failure to accurately forecast inflation, the neglect of the money supply, and the lack of bold policy moves have contributed to the current predicament. Taming inflation will require decisive action, potentially resulting in adverse consequences for the economy. Striking a delicate balance between curbing inflation and sustaining economic growth remains a formidable task for monetary authorities.