Near the beginning of the Coen brothers’ classic O Brother Where Art Tho? our three escapee heroes find themselves in a barn surrounded by local law enforcement, with no clear way out — leading George Clooney’s Ulysses McGill to proclaim: “Damn, we’re in a tight spot!”
Bank of England governor Andrew Bailey and his eight fellow members of the monetary policy committee might empathise.
In comments reported by the FT over the weekend, Bailey said the Old Lady of Threadneedle Street “will have to act” to control inflation, after the figure hit 3.2 per cent in the year to September, 1.2 percentage points up on where it was the previous month. Markets have taken Bailey’s remarks as a hint that rates will not only rise from their current level of 0.1 per cent later this year, but that monetary policy will continue to tighten in the years to come. The two-year gilt hit 0.72 per cent on Monday morning, the highest level in two years. It’s also almost 50 basis points higher than the equivalent yield on the two-year Treasury.
The rise in inflation between August and September was the sharpest since the Bank of England gained independence to set monetary policy as it sees fit back in 1997. Yet Bailey and other members of the BoE still insist the current bout of price pressures is transitory. So what explains the signs that the Bank is seemingly willing to start tightening?
The obvious answer is that Bailey and others on the MPC are becoming concerned that inflation, while still ultimately temporary, will stay higher for longer than anticipated, and that this will dent the Bank’s credibility. The fear will be that, in such a scenario, inflation expectations will shoot up, in turn driving up actual inflation by feeding into people’s behaviour.
The Bank is not alone in finding itself in a tight spot. Central banks the world over are wrestling with what to do in the face of rising inflation from a global supply shock. But with the level of extra uncertainty facing the UK economy — from the fall in immigration to the rolling-off of fiscal support in the form of the recent cuts to universal credit, the end of the furlough scheme, and the incoming national insurance hike — the stakes are higher than in other countries.
A big problem is that the theory that underpins modern central banking says an awful lot about how to deal with a demand shock, like a credit crisis, but little about how to contain the impact of supply shocks. This has led to a view that central banks should react to changes in demand, but not supply — these are deemed temporary. Those that have not followed this rule have often come unstuck. The European Central Bank’s decision to raise rates in 2011 in response to a rise in oil prices is widely viewed nowadays as a severe policy error.
Yet the BoE is now considering doing the same thing when there is little evidence that demand is driving inflation.
That might seem like an odd thing to say given the economy is rife with shortages for all sorts of products and labour. But it also happens to be right.
Dominic White, an economist at research shop Absolute Strategy Research, told FT Alphaville what we’re witnessing is a “relative supply and demand issue” with people spending less on services — whether that’s eating out at restaurants or going on holiday — and more on durables, like household electronics and cars. In short, demand has shifted, rather than increased. As White points out, the UK economy is a fairly open one, with imports and exports making up over 50 per cent of GDP, so that’s put acute pressure on supply, in turn leading to price rises. Combine that with a radical reset in our terms of trade with Europe and spiralling global energy prices, and you end up with the almighty mess we’re in right now.
Where we do have some sympathy for the Bank (and indeed central banks in general) is that, unlike Eyjafjallajokull’s eruption in 2010, there is the real threat that supply shocks prove both more enduring and frequent. That’s not only due to the pandemic. Disruption from extreme weather events, and government attempts to deal with climate change, will continue to produce spikes in prices too. Dario Perkins, a managing director of global macro at TS Lombard, told FT Alphaville on the phone earlier: “We’ve had 20 years where everything is about demand shocks . . . we haven’t lived in a world where supply shocks dominate demand shocks.”
The threat that inflation expectations become unstuck does become more real if a series of supply shocks occurs. The trouble with this is that, if you’re sitting in Threadneedle Street thinking that your credibility’s about to get shot, is a small rate hike really going to solve that?
BNP Paribas Asset Management’s Richard Barwell argues that a couple of rates hikes pleases no-one: it will be too much for those who think the rise in prices will prove temporary, and too little for those who think the UK is reentering the dark days of the 1970s.
My best guess is that not only will the increase in inflation prove temporary, but that some of the increase in the price level will prove temporary too. When the stress in supply chains and wholesale gas markets unwinds then prices should fall back too which means that there may be nothing at all for Governor Bailey to do. Do we really think that a temporary disruption in the supply of semiconductor chips will have a permanent impact on car prices? To be fair, if you lose control of inflation expectations in the meantime then the BoE may need to respond aggressively. Only a significant correction in rates is likely to restore credibility at that point. Raising rates from 0.1 per cent to 0.5 per cent is unlikely to make much difference.
In the absence of clear guidance from the BoE, markets may conclude that Bailey will keep delivering hikes until spot inflation drags inflation expectations back down or the recovery stalls altogether. Barwell thinks what the Bank needs to come up with is a clear, credible state-contingent plan:
You explain that rates can stay low because inflation will soon be low again, but you acknowledge that a significant increase in rates might prove necessary in the worst case scenario and you explain how you will decide when action is necessary. You have to be willing to discuss the plan for interest rates in public. If you cannot or will not talk about how you will respond to events in the future then you may feel forced to make larger adjustments to interest rates today in response to questions about your credibility.
Will that happen? We’re not holding our breath. When it comes to the Bank’s messaging of late, another film featuring Southern chain gangs come to mind. This time we’re thinking of Cool Hand Luke: “What we’ve got here, is a failure to communicate.”
Source: Economy - ft.com
