Why the Bank didn’t fight back harder – and what happens next

Recession fears have held back attempts to control inflation, write and

The Bank of England has been walking on a tightrope for months, torn over how fast to raise interest rates. But as other central banks gear up to fight rising inflation, it is beginning to look excessively cautious.

The nine-strong Monetary Policy Committee (MPC) is divided over which, painful, path to go down: while there is a need to curb price rises with higher borrowing costs, the economy could also need support as recession looms. Yesterday, the more wary side prevailed, resisting the pressure to fight inflation harder.

On one side are the hawks: Jonathan Haskel, Catherine Mann and Michael Saunders. These three – all external members – voted to raise interest rates to 1.5pc, in what would have been the largest increase at a single meeting since the mid-1990s.

The trio see such a hike as necessary to stop domestic price pressures building, put a lid on rampant inflation and demonstrate the Bank is doing its job of keeping costs under control even as the economy is battered by many unprecedented shocks. On the other side are Governor Andrew Bailey, his deputies, the Bank’s chief economist Huw Pill and the final external member of the committee, Silvana Tenreyro.

They are more optimistic on inflation, albeit for dire reasons. The group notes Britain’s economy is already shrinking, which should quash demand and prices.

With GDP slipping, and set to be further hammered by higher prices later in the year, families and businesses are going to feel very much like they are in recession.

Once global prices fall, or even stop rising, inflation should slow of its own accord, and a recession means domestic price pressures should slow as well, with unemployment edging up and businesses no longer able to ramp up costs charged to consumers.

If that analysis is correct, the Bank only needs to do the bare minimum to show it is taking inflation seriously – the slump will take care of the rest. In this line of thought, officials would make the recession worse if Threadneedle Street ramped up interest rates too much. Inflation would eventually be pulled too far below the 2pc target, leaving the Bank, and the economy, in the depressed position it has been trying to escape since the financial crisis.

A third camp was expected in favour of holding rates, but that stance has been eliminated by the sheer scale of the inflationary threat. Its disappearance, showing that resistance to higher rates is weak, is one reason the pound rose on the Bank’s modest 0.25 percentage point rate rise, to 1.25pc. In a sign of the uncertainty, markets were split between a 0.25 and 0.5 percentage point rate rise.

The Bank knows going slowly is risky. The MPC promises to “be particularly alert” to signs inflation is bedding in for the long haul and will “if necessary act forcefully”.

If it is wrong again on the scale, speed and persistence of inflation, that force will be needed soon. There has been plenty of uncomfortable reading for the MPC recently as they failed to accurately predict Britain’s current economic situation. But few documents should be more painful than their own report last May, in which the panel breezily dismissed inflationary pressures as “transitory developments” that “should have few direct implications for inflation over the medium term”.

At the time, they predicted inflation would peak just shy of 2.5pc by the end of 2021, before returning to near the 2pc target. Rather than worrying about raises, there was talk of negative interest rates.

Fast-forward just over a year and the picture is starkly different. In that time, the MPC has hiked its expectations for inflation eight times, saying yesterday that consumer prices will be more than 11pc higher in the year to October.

Despite warnings from former chief economist Andy Haldane, the Bank spent most of last summer insisting price rises would peter out. Yet by last autumn it had become clear the factors underpinning inflation were stickier than initially thought. Since then, the Bank has been playing catch-up.

It is impossible for the Bank, which

‘The MPC has hiked its expectations for inflation eight times, saying that consumer prices will be more than 11pc higher in the year to October’

‘Time to have a word with those members of the Monetary Policy Committee who only last year were keen on negative interest rates’

has tools to influence demand but not supply, to directly tackle all causes of inflation. Bailey has previously said 80pc of the UK’S current inflation overshoot is imported, prompted by factors such as lockdowns in China and the war in Ukraine.

But higher rates would help push up the pound, potentially taking the edge off import costs. And, by Bailey’s argument, there is still one fifth of the overshoot caused by domestic factors. When the overshoot is as large as it is, domestic pressures equate to almost two percentage points on the rate of inflation, which is worth reining in. It begs the question why the MPC has not gone further.

Despite a false start last November – when the MPC stunned markets by holding rates at a record low – the Bank was quicker out of the gates than its biggest international peers.

But the US Federal Reserve, the sleeping giant of global monetary policy, has recently awakened from its inflationary slumber.

The Fed is now raising rates at a far faster pace than the Bank, including a 0.75 percentage point increase on Wednesday. Despite starting from a similar baseline of 0.25pc, versus the Bank’s 0.1pc, the Fed’s funds rate is now at 1.75pc – half a point higher than the Bank Rate.

The rise – which makes it more lucrative for investors to hold dollars – is further strengthening the US currency, which was already being buoyed by its safe-haven credentials as markets sell off in response to global monetary tightening. It is a vicious cycle for the British pound, which has dropped to its lowest levels since the start of lockdowns.

Markets expect the pace to pick up from here, pricing in a series of half-point rates at the next three meetings, followed by another two quarter-point climbs to take the rate to about 3.25pc next year. Still, criticism of the MPC is building.

“Although rarely used, the Governor’s eyebrows remain part of the Bank of England’s armoury. Since I left in 2013, mine have been resting. But the latest inflation rate of 9pc led them to rise sharply,” wrote Lord King, the Bank’s former governor, in The Spectator yesterday.

“Time to have a word with those members of the Monetary Policy Committee who only last year were keen on negative interest rates.”