The Bank’s dilemma

Later this week the Bank of England’s Monetary Policy Committee (the MPC) is due to hold its next meeting, and once again all eyes will be on them to see if they raise rates from their current 0.75%. With inflation currently around 7% (that’s nearly ten times base rate!) a further raise would seem to be an obvious decision, and indeed that is what most commentators are predicting. But there are a number of reasons why this is not such a foregone conclusion as it might appear, and a number of issues which could cause the Bank to hesitate.

To many people, this will seem odd. With inflation already uncomfortably high and forecast to go higher still before it eventually (we all hope) starts to ease, to have the Bank’s main lending rate more than 6% below headline inflation is not only unprecedented in the era of independent central banking but also, so many think, unwise in the extreme and risking even higher inflation in the months to come.

It is true that in the 1970s, base rates were even further behind inflation (in central-bank speak, “real rates were even more heavily negative”), but that was when politicians decided what interest rates were and had political reasons for suppressing them. Surely the whole point of giving the Bank autonomy over the interest rate decision, as Gordon Brown did 25 years ago this month (in May 1997, almost immediately on becoming Chancellor) was to remove from the politicians the temptation to meddle with the health of the economy for party political advantage? The Bank does not face the same political trade-offs, and so should be freer to act; indeed one can almost hear the cries of “Come on Bank, get on with it!”

But this is to misunderstand two important factors that affect how the Bank’s MPC takes its decisions. The first is that not all instances of inflation are the same, and the second is that the Bank’s independence is not absolute.

Let us start with the several different types of inflation. If you ask the average person in the UK how inflation works and what the Bank’s role in controlling it is, you might get an answer along the lines that prices go up when too much demand is chasing too little supply, and that the Bank’s response of raising interest rates is meant to curb this demand, by discouraging marginal spending until it is back in line with supply. That’s not a bad answer – it is in fact very largely how house price inflation works – and the fact that this level of understanding is quite widespread in the general public is itself a credit to the Bank and to its efforts over the 25 years of its independence to explain itself to the population at large.

Probing a bit further though, we need to ask why demand is outrunning supply. This is where it gets a bit more complicated: it could be because of problems on the supply side, or it could be because of an increase on the demand side. And the challenge facing the Bank is that right at the moment there are large elements of both.

On the supply side, there are shortages due to world trade and international shipping not yet having fully recovered from the pandemic (and in the case of China, an important source of so many inputs for our economy, very far from fully recovered as their lockdowns increase), and there are specific shortages of energy and food products due to the war in Ukraine. All of these are both limiting the availability of goods and making what is available more expensive – in the case of energy, much more so.

On the demand side, labour shortages and the inability of employers to fill job vacancies – itself a complex position in which the effects of the pandemic and of Brexit are intertwined – is leading to pressure for wage increases, and government spending, however helpful for families feeling the pinch caused by energy price rises, is by adding to the amount of money in the economy adding further fuel to the inflationary fire.

The problem for the MPC is that in countering these many interlocking influences on the economy, it only has a very limited range of tools it can use. Raising interest rates might curb demand (though actually the huge increase in energy costs is already doing that to some extent without the Bank adding to families’ problems[1]), but it does nothing to free up world shipping, or force Putin to end his assault on Ukraine, or reduce the cost of imported oil and gas, or encourage Xi to abandon his hard-line zero-covid obsession and restart China’s economy, or make it easier for employers to fill vacancies caused by EU workers not returning to the UK.

Nor is the other tool the Bank has, its balance sheet and Quantitative Easing (QE), a silver bullet either.

This last comment needs a bit of unpacking, not least because while understanding of the workings of the interest rate channel is actually quite high in the general public, understanding of the way QE and the Bank’s asset purchase schemes have worked over the last dozen years is much less widespread – and therefore understanding of how its unwinding (known as Quantitative Tightening or QT) might work is similarly shaky.

For most people, QE has been understood as “Bank buying assets” and therefore “Bank supplying economy with lots of money”. Which, it is assumed, stopped the economy sinking into deflation and recession in the 2010s, after the global financial crisis, but is now fuelling inflation – it being widely believed that “the central bank printing money” is a recipe for disaster and Weimar-style hyperinflation. Ergo, all we need is QT, in which the Bank unwinds its purchases and removes money from the economy, and all will be well.

Unfortunately, it is not that simple. As my colleague Gabriel Stein notes in his recent piece “What QT will do”, the effect of unwinding QE and reducing the central bank’s balance sheet depends crucially on who buys the assets the central bank is unloading. Gabriel’s piece looks at the case of the Federal Reserve, but the position in the UK and with the Bank is exactly the same, and I do encourage our readers who want a more technical exposition of QT and its consequences to read his piece.

In a nutshell, QE only increased money supply to the extent that the non-bank sector of the economy sold assets and received cash, and QT will only reduce the money supply to the extent that the non-bank sector will buy the assets back and use cash to do so. And since the former was “very little if at all”, the likelihood that QT will seriously reduce the money supply looks likely to be equally small[2].

So when the MPC meet on Thursday they will face an inflationary situation with multiple causes and little certainty that either of their main tools – interest rates and the size of their balance sheet – will have much effect on most of them.

That is not to say, though, that an increase in interest rates will have no effect at all on anything.  It will impact anyone who is borrowing money, by increasing the interest charges they face. And the awkward fact for the Bank is that prominent among those most seriously affected are the Government (the biggest debtor in the economy, and right now Rishi Sunak really does not want to see the cost of servicing the national debt go up even higher), the general public (who are already being stretched by general inflation, especially food and energy costs, and large sections of whom have largely reduced their optional spending to bare essentials) … and the Bank itself, because those bankers’ balances we mentioned are interest-bearing[3].

As a trio of consequences, worsening the government’s fiscal position, adding pressure to family finances and increasing the amount the Bank pays the banking sector in interest is not an attractive cocktail politically. And if it tips the economy into outright recession and piles further grief on families, it becomes extremely unattractive indeed.

And this leads to the second point that we made above, that the Bank’s independence is not absolute, and it cannot act with complete disregard for its reputation and the way its actions are perceived. The Bank may be autonomous in setting the level of interest rates, but it does not do so in a vacuum, and no central bank can be so single-mindedly focused on inflation that it ignores all other aspects of the economy and all side effects of its actions. That would be irresponsible in the extreme, and indeed the last central bank to adopt such a narrow interpretation of its mandate and pursue a hard line on inflation “whatever the consequences” (the Bundesbank in 1990-92) brought about first the ERM crisis of 1992 and second, as a direct result, its own neutering as it was subsumed into the ECB.

Instead, the Bank always has to be mindful of the wider economic situation, and it also has to be mindful of the views of the political authorities, specifically the Chancellor’s. Indeed, even the most independent of central banks have to accept that what the politicians have granted, they can take away, and central bank self-censoring (in other words, tailoring their actions to avoid goading the politicians into action against them) is part and parcel of central banking reality, however much they may claim otherwise.

It was in fact ever thus, even for the most independent of central banks such as the US Federal Reserve. The Federal Reserve Act of 1913 may specify the central bank’s independence from the Executive (ie, the President), but as President Nixon remarked in 1970 when appointing his friend Arthur Burns as Fed chairman, “Of course I respect the Fed chairman’s independence. And I am confident that he will independently conclude that my views are the ones that should be followed”.

Nixon didn’t do nuance, and as threats go, it wasn’t exactly subtle. And Burns responded by running a very accommodative monetary policy and presiding over some of America’s highest peacetime inflation ever. But even more softly spoken politicians have a way of making central bank governors aware of what they think.

And so the MPC will have more to discuss on Thursday than might on the surface seem the case. To do nothing will cause the critics who accuse them of being slow to react to inflation to redouble their attacks, but they face a multi-headed hydra with one weapon (interest rates) that might backfire on them, another (QT) that is little understood, and a real risk that if they over-react they will tip the economy into recession.

The likelihood remains that they will indeed raise interest rates again, for the fourth time this cycle. But the case is nothing like as open-and-shut as some commentators are suggesting, and the discussion on the MPC may well take a lot longer than people expect.


[1]              This is a generalisation: the energy price rises are in practice of course affecting different people in different ways.  The least well-off sector of society have already cut discretionary spending to the minimum and are likely to resort to borrowing to maintain consumption.  This does not cut demand much or therefore inflation.  But others who are better off will respond to the energy price rises by cutting their free spending – for them the energy price rises are not that different from a rise in their mortgage outgoings, for example. Overall, the expected response across the whole economy will be to dampen demand in the economy and so it should have some effect on inflation.

[2]              The main result of QE was that the Bank bought gilts from the banking sector, and they in turn simply left the resulting proceeds on their accounts at the Bank: the Bank’s latest balance sheet, for 20 April, shows that asset purchases have totalled £867 billion or so, while bankers’ balances at the Bank total some £952 billion. In other words, the banks exchanged their asset holdings for cash, and the Bank bought the asset holdings by crediting the banks’ accounts with itself, and far from QE being “the Bank running the printing presses”, the net effect on the wider money supply was very limited indeed.

[3]              Which leads to the politically awkward fact that every 1% rise in interest rates increases the amount of interest the Bank pays the banking sector by nearly £10 billion a year. Whatever the economic reasons for this, the PR of “Bank subsidises banking sector to the tune of tens of billions of pounds a year” looks awful!