Don’t blame the Bank for soaring prices – just cut taxes
A reduction in VAT from the Government and care over wage rises by business are the way out of this crisis
With inflation now at 9pc and rising, the Bank of England and its Governor are facing fierce criticism for failing to prevent this biggest surge in prices since the 1980’s. After all, the primary objective given to the Bank when it was established as an independent economic regulator was to keep inflation at or about 2pc. Never the less, this criticism is unfair and potentially dangerous in the current circumstances.
Classical economic theory recognises a direct link between the volume of money in circulation and price levels, controlled by the central bank through its role in setting interest rates and selling or buying bonds to manage liquidity. If demand in the economy exceeds supply and causes inflation, according to this theory the bank can act to raise rates and reduce both money supply and demand until inflation is brought under control.
While this is works perfectly well in a closed economy – one without external trade – in reality it does not apply so well in an open economy where the cause of inflation is a rise in the prices of external goods such as oil and food. The consequence of the war in Ukraine has been to create real shortages of core commodities. This external adjustment in price levels means a real decline in living standards for the Western economies that depend on these imports. Asking the Bank of England to tighten monetary policy at the same time will not avoid this – indeed reducing domestic demand in order to temper inflation could only work if it further depressed living standards and drove down domestic prices, increasing the risk of recession. Following a period when the Government has pumped billions into the economy to keep it afloat during the pandemic, this would be perverse.
The only practical way to manage the inflation risk actually lies with Government, along with the business community, in providing leadership to reduce inflationary expectations. While the reduction in living standards caused by the global crisis may not be avoided, a one-time price adjustment only becomes permanent inflation if the pressure to offset it leads to a long-lasting cycle of higher wages continually chasing – and so causing – further increases in prices.
Large private and public sector employers can try to mitigate this by weighting the increase in their wage bills to give much larger increases to those on the lowest wages, with higher paid employees accepting rather than pushing to offset the current inflation. Another part of the solution would be for the Government to use Brexit freedoms to introduce a sharp, temporary reduction in VAT, which would act directly to reduce the headline rate of inflation over the coming months. Over time the VAT rate could be gradually raised again, but the highest rate of inflation would have been avoided.
Such a tax reduction would of course add to the UK’S borrowing at a time when it is already uncomfortably high. However, the alternative option of rising interest rates and putting further pressure on living standards would put pressure on government borrowing too. Exceptional circumstances require exceptional measures – and simply relying on economic theories designed for different conditions or bashing the central bank won’t provide a better outcome.