The Bank of England has underestimated the risk inflation poses to stability | Gerard Lyons

With inflation set to exceed the Bank’s 2% target in 2022 – many people will be hit hard by a cost-of-living crisis

The Bank of England has badly misjudged the persistence of inflation. It is also underestimating the risks that its policies pose to financial stability.

The problems, however, don’t stop there. For much of the last decade, its policies of low rates have contributed significantly to inequality, boosting asset and house prices.

Also, it has been too quiet on one of the economy’s persistent challenges: namely, why do banks barely lend to small and medium sized firms? This problem, labelled the Macmillan Gap, was first identified in 1931 and the Bank, in 2019, acknowledged it was a mammoth £22bn.

The immediate challenge for the Bank, though, is inflation. The annual rate of consumer price inflation (CPI) has risen this year from 0.7% in January to 5.1% in November. It looks set 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 about 7% in April, and to stay elevated, before decelerating to 3% by early 2023. Notably, retail price inflation (RPI), which is used to determine many statutory prices including rail fares and student loans payments, tends to be higher than CPI and currently is 7.1%.

When the pandemic hit, the Bank sensibly cut rates to a record low of 0.1%. However, it also engaged in large scale printing of money via Quantitative Easing (QE). It now holds £20bn of corporate bonds and an excessive £875bn of gilts, making it the largest holder of government debt.

As the economy recovered this year, the Bank continued with QE when it needn’t have. And, as inflation rose, it could have hiked rates but didn’t. Then, this month, as the economy faced an imminent slowdown because of Omicron, it decided to raise interest rates from 0.1% to 0.25% and halt QE.

Such poor judgment doesn’t augur well for the future. Regarding inflation specifically, the issue is which ‘p’ it will be – will it pass-through, persist or be permanent? It doesn’t appear permanent, as the triggers are linked to temporary supply-shocks because of the pandemic.

Mistakenly though, the Bank thought inflation would pass-through quickly when it always looked likely to persist, as firms raise prices to maintain their margins in the face of rising costs and, as it persists, this leads inflation expectations to rise and people to seek higher wages.

Sometimes the consensus is slow to react to shifts in the inflation climate. This happened in the early 1990s when we moved from high to low inflation. Likewise, in the 1970s when the move was from low to high.

Many might wonder why the Bank raises rates when it can’t do anything to control, for instance, rising energy prices. The challenge, though, is the second-round effects. Hence the Bank’s focus on inflation expectations, which have risen, and on the tighter labour market.

Monetary conditions also matter. Amazingly though, despite this, the Bank’s quarterly Monetary Policy Report never mentions the word money – suggesting they pay a low priority to monetary conditions.

Regardless of whether you’re a monetarist or not, monetary developments are a key indicator on the dashboard – essential to keep an eye on.

It’s not only 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, and so we should be concerned.

Low interest rates mean financial markets don’t price properly for risk. This encourages speculative behaviour, which is exacerbated by the scale of QE. Moreover, because the Bank is a non-commercial buyer, the scale of its buying may be distorting the price of government bonds and therefore yields.

Crucially, tightening policy isn’t just about raising rates but also about what happens to the Bank’s holding of bonds, as that impacts longer-term borrowing costs.

After 2008, monetary policy became the economic shock absorber. Now, monetary policy has gone from being carefree to careless – 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


Gerard Lyons

The GuardianTramp

Related Content

Article image
Bank of England: rapid GDP rebound likely as vaccines take effect
Economists say lenders should still prepare for negative interest rates in case of downturn

Phillip Inman and Kalyeena Makortoff

04, Feb, 2021 @7:53 PM

Article image
Inflation drop paves way for new round of QE
Office for National Statistics says inflation rate dropped to 2.8% in May and cites falling petrol prices as main factor behind fall

Heather Stewart

19, Jun, 2012 @3:36 PM

Article image
Inflation is poised to top 4%: is the Bank of England asleep at the wheel?
Analysis: Threadneedle Street is adopting a wait and see policy and keeping interest rates unchanged

Larry Elliott Economics editor

23, Sep, 2021 @1:48 PM

Article image
Rise in inflation and slow wage growth raise new fears over economic recovery

Increase in consumer price index to 3.5%, coupled with data indicating that average pay rises are down to 1.1%, offsets better news about unemployment

Phillip Inman, Heather Stewart and Josephine Moulds

18, Apr, 2012 @7:05 PM

Article image
Household finances squeezed by food and travel costs as inflation continues to rise
Families had £166 a week of discretionary income to spend in July, according to the Asda Income Tracker – 6.4% lower than at the same time last year

Phillip Inman

28, Aug, 2011 @11:02 PM

Article image
Recovery likely to push inflation above 3% by end of year, says Bank
UK interest rates put on hold with post-Covid boom expected to have impact on prices in coming months

Phillip Inman

24, Jun, 2021 @4:02 PM

Article image
Rising inflation could trigger global sell-off that would harm UK, says Bank
Risky asset prices in several markets are at historically high levels and could be primed for sharp fall, it adds

Richard Partington Economics correspondent

08, Oct, 2021 @11:26 AM

Article image
Bank of England sharply raises UK growth forecast
Central bank predicts economy will grow by 2% this year as consumers and businesses appear to shrug off Brexit blues

Katie Allen

02, Feb, 2017 @12:46 PM

Article image
Bank of England ‘addicted’ to creating money, say peers
BoE must be more transparent and justify use of quantitative easing, says Lords report

Larry Elliott Economics editor

15, Jul, 2021 @11:01 PM

Article image
Bank of England pumps an extra £100bn into UK economy
Quantitative easing expanded to help Britain recover from coronavirus crisis

Larry Elliott Economics editor

18, Jun, 2020 @11:48 AM