Bank of England should cut rates immediately

‘Shadow’ MPC has the right policy to head off recession and possible debt-deflation by 2025

‘We may wake up next year to discover that little has changed since the era of ultra-low inflation’

Inflation across the West is being smothered slowly by cut-price Chinese imports, falling commodity costs, and a contraction of the domestic money supply on both sides of the Atlantic.

British inflation is likely to fall below 2pc over the first half of this year, 18 months earlier than the Bank of England’s forecast. Capital Economics says it may be hovering near zero by late autumn.

The Monetary Policy Committee (MPC) was too slow to act when money growth was spiralling out of control in 2021. It fuelled the fire very late in the day with a second round of pandemic quantative easing (QE).

It now risks repeating the opposite mistake by keeping interest rates too high, for too long, and by persisting with quantitative tightening (QT) despite a fall in the M4 money aggregates and a squeeze in credit. Two members of the MPC voted to raise rates yet further yesterday.

Only Swati Dhingra dared to buck the oppressive consensus by voting for a cut.

This is turning into a fresh drama over the credibility of the Bank of England under Governor Andrew Bailey. A growing chorus of critics has warned that policy is becoming viciously restrictive.

The damage will not become obvious until it is too late. The lag times are typically one to two years.

Economists on the “shadow” MPC, hosted by the Institute of Economic Affairs, have thrown down the gauntlet by voting unanimously for an immediate rate cut to head off recession and possible debt-deflation by 2025. They also called for a halt to QT bond sales until liquidity has recovered.

“The economy is barely growing and inflation will be back to target by the middle of the year, so why on earth is the Bank of England keeping rates at 5.25pc?” said Trevor Williams, the coordinator of the shadow committee.

He voted for a 50 point cut followed by another 50 points in April, arguing that the implied neutral rate is 3pc to 3.5pc at this juncture.

The overhang of money left by excess savings during Covid has entirely disappeared and this in turn has set off a slide in retail sales, in contrast to America where the excess money stock was larger and peaked later, and where it is at least arguable that consumers still have unspent reserves. Besides, Washington is spending wildly, running a war-time fiscal deficit near 8pc of GDP.

“Money growth in the UK is desperately low and it’s becoming dangerous for the economy,” said Peter Warburton, a credit expert and founder of Economic Perspectives.

“Insolvency rates are rising quickly and lenders are limiting what kind of borrowers they are willing to take on.

“It is singularly inappropriate to continue shrinking the balance sheet when liquidity and credit are so weak,” he said.

Analysis by the Boston Fed shows that US companies suffer the peak impact of tightening a year later as they are forced to refinance, or as debt covenants are breached. This is amplified through the “financial accelerator channel”.

The picture is unlikely to be that different in the UK where Begbies Traynor estimates that 539,900 businesses are in “significant” financial distress, and 47,000 entered 2024 on the verge of collapse.

The Bank of England is worried about wage growth running at 7.2pc over the three months from August to October, compared to a year before. But this is a lagging indicator. The rise in weekly earnings was almost zero over the last two months of published data: £663 in October compared to £661 in August (ONS data).

“It is not as simple as inflation falling to target in the spring and the job being done,” said Governor Bailey. Indeed not, but the Bank is forecasting that inflation will rebound and rise above 2pc in the third quarter, which is highly questionable. Capital Economics says headline inflation is heading for 0.3pc zero by September for mechanical reasons linked to the energy price cap, now expected to fall by 16pc in April and a further 8pc in July.

Title Transfer Facility gas contracts in Europe have dropped to €30 MWH, eight times lower than during the panic of mid-2022 and lower than before the invasion of Ukraine. Lithium carbonate prices have crashed by 85pc due to oversupply. Nickel has halved. Cobalt is down 64pc. These inputs will feed into cheaper EV batteries just as new technology delivers fresh leaps in cost efficiency. Car deflation is coming your way.

You can make a case that the Russia-opec cartel will succeed in pushing up oil prices, but the clearer pattern is that frackers in Texas are snatching market share. The Saudis have been unable to drive Brent to the $90-100 range even after repeated cuts in output. The “oil-intensity” of world GDP is in any case a fraction of what it was in the 1970s. The broad commodity index has been on a downward slope for 18 months.

In my view, the Bank of England, the European Central Bank, and the Fed have failed to keep up with events in China, and are therefore underestimating the deflationary trade shock that is already hitting, and is likely to intensify, as Xi Jinping reverts to all the old pathologies of the Chinese development model.

Investment is back to the exorbitant level of 42-44pc of GDP, building up yet further industrial and manufacturing capacity that China cannot absorb and will be dumped on the world.

Chinese export prices have fallen 12pc in dollar terms over the last year, and 18pc in euros. China’s annual trade surplus in goods is running at $900bn, large enough to distort global trade and to constitute a major shock for Europe as it languishes in semi-slump. The falling price of Chinese goods explains the mystery of how the US can run a Rooseveltian budget deficit at the top of the cycle yet at the same time see a drop in core personal consumption expenditures (PCE) inflation to just 1.5pc (annualised) over the last three months.

It is a fair bet that inflation will fall further as fiscal largesse fades in the US, and even more so in Europe, over the course of 2024.

There is consensus of sorts that we have jumped to a new regime of permanently higher inflation and bond yields since the pandemic.

This has never struck me as selfevident. Artificial intelligence is a deflationary force. So is Moore’s Law of semiconductor chips, poised for the next leap forward using compound materials. So is the learning curve of clean-tech. The demographic crunch that pushed Japan into deflation has since spread to Korea, China and much of Europe.

We may wake up next year to discover that little has changed since the pre-covid era of ultra-low inflation, when the natural rate of interest was pinned to the floor, and deflation was knocking at the door.

The Bank of England is hedging against the wrong risk.