Bank of England credibility is hanging by a thread

If the public loses faith in its ability to contain price rises, the consequences will be truly catastrophic

Price stability, Alan Blinder, a former vice-chairman of the US Federal Reserve, once observed, is when most people stop talking about inflation. That happy state of affairs is unfortunately not the case today; seemingly everybody is talking about inflation, and the crunch in living standards likely to follow.

As it is, Boris Johnson’s premiership is already running into some bad political turbulence, but it will be nothing compared with what is to come if inflation catches hold. That’s beginning to look like a real possibility.

Every 10 years or so, there is a crisis of confidence in the ability of the Bank of England and its fellow central banks around the globe to provide the monetary and financial stability they are supposed to. The last such occasion was the financial crisis, which these so-called “Lords of Finance” collectively and hopelessly failed to anticipate, with dire consequences for Western economies.

Today, it is our old friend inflation that has come back to haunt. Not since the Bank of England was given independent control of monetary policy more than 24 years ago has its core function of maintaining price stability looked so much in doubt.

Before the pandemic, inflation was happily chugging along at close to its 2 per cent target; last month, the annual rate surged to 4.2 per cent, its highest in nearly a decade, with more than 5 per cent widely expected by the spring of next year.

These inflationary pressures are by no means confined to Britain. Large parts of Europe are seeing much the same thing, and in the US it is even worse. In none of these jurisdictions did the central bank foresee the scale and likely durability of the present spike in prices. Central banks also share an apparent determination to regard the pressures as “transitory” and therefore not yet worthy of decisive action.

When people start to say of the central bank, “sorry, but we don’t believe you anymore”, it’s time to run for the hills. That’s precisely the risk they face today – a catastrophic loss of credibility.

None of this should come as any surprise. That monetary policy has lost what Mervyn King, a former governor of the Bank of England, this week called its “intellectual anchor” has been obvious for a long time now.

Out of politeness to his former peers, I suppose, Lord King posed this judgment as a question in a speech to the Institute of International Monetary Research – rather than asserting it as an unarguable truth. But there was no doubting the thrust of his analysis: monetary policy has lost its compass.

King’s starting point is that the old idea that inflation reflects “too much money chasing too few goods” has been replaced by the view that it is driven solely by expectations, and that it is central banks that determine those expectations.

Thus we have arrived at what King calls the “King Canute” theory of inflation – that inflation will remain low and well-anchored simply because central banks say it will be. The difference is that Canute was attempting to demonstrate to his courtiers that even he could not hold back the tide by simply commanding it; central bankers have fallen victim to the delusion that they can.

In the early days of the Bank of England’s Monetary Policy Committee, King recalls, “we pored over various forecasts for inflation produced by Bank staff for different interest-rate decisions. No matter the path of interest rates we simulated, inflation always returned to target. Why? Because in these models, the only determinant of inflation in the medium term was the official target.”

Common sense alone tells you that if you print lots of money, then it is almost bound eventually to result in price inflation – if one pound is replaced by two pounds, then one pound is going to buy you fewer goods and services than it previously did.

It is impossible to reflect the subtleties and the heavily caveated nature of King’s argument in an article as short as this, but essentially what he is saying is that for all their technical expertise and brain power, central banks have lost the plot. At no point has the Bank of England been able to offer a plausible explanation for precisely how its repeated rounds of quantitative easing benefit the economy, or the channels through which that benefit is supposed to operate.

It should therefore come as no surprise that virtually everyone outside the Bank thinks of QE not as a tool for ensuring the inflation target is met but as nothing other than straight monetary financing of the Government’s burgeoning budget deficit.

Without the backstop of the Bank of England to buy up its debt issuance, the Treasury would be up the proverbial without a paddle. Small wonder that the politicians dare not criticise – it’s not just breaking the taboo of political interference in monetary policy they worry about. They’ve also got skin in the moneyprinting game.

And yet inevitably, there will be a price to pay – higher inflation and an eventual caning by the voters.