The Bank of England’s credibility has become severely compromised

Assessing the economy is like shooting at a target that is always moving – and policymakers keep missing

‘A good reputation is hard to earn but easy to squander’

The Bank of England appeared to “bottle it” when it opted to increase interest rates by only 0.25pc last week. It is looking as though the Bank has again missed a trick and reinforced its reputation for being “behind the curve”.

Not good.

A good reputation is hard to earn but easy to squander. When it comes to controlling inflation, central banks’ reputations matter because they can influence both wage and price setting behaviour and financial market prices.

A good few analysts and market operators had expected the Bank to increase rates by 0.5pc, especially after the US Federal Reserve had increased interest rates by 0.75pc. And on the same day that Threadneedle Street announced its small rise, the Swiss National Bank shocked the markets by announcing a completely unexpected increase in interest rates of 0.5pc, in response to a jump in Switzerland’s inflation rate from 2.5pc in April to 2.9pc in May. (If only we had their inflation problem!)

What made the Bank of England’s caution all the more surprising is that it came at the same time it announced that it has now raised its forecast for peak inflation to 11pc, which it sees happening in October.

A lot of economic analysis and commentary is focused on how high the inflation peak will be. This is indeed an important matter. But I don’t think it is anything like as important as what happens afterwards.

On an optimistic view, the inflation rate will fall back quite easily without much extra prodding from the Bank. But I take a less benign view: even though inflation will subside from its peak, it will not come back down easily to the 2pc target without a good deal of extra pressure.

The Bank has insisted that it has no power to stem or even reduce inflationary pressures arising from the supply side, including global energy prices. This is a bit of an exaggeration, but only a bit. You could just about say that how high the peak inflation rate climbs is out of the Bank’s hands.

But that is not true for what happens to inflation beyond the peak. Of course, even if energy prices do not subside, inflation should fall back quite rapidly as this year’s sharp energy-driven increases in prices fall out of the annual comparison. Yet how far and how fast inflation falls back will be influenced by domestic economic factors as well: the state of aggregate demand, the level of wage increases, businesses’ expectations about future inflation and exchange rates. The Bank’s actions – and its reputation – can have a key bearing on these matters, especially the latter.

There is no necessity for UK interest rates to participate fully in the general upswing in official interest rates now under way pretty much across the world. But if they don’t, then the exchange rate will tend to suffer.

There has recently been a lot of frothy and ill-judged comment suggesting that the pound has become some sort of banana republic currency. This is nonsense.

Admittedly, sterling is down by almost 9pc against the dollar since the beginning of the year, but this is mostly down to the fact that the US currency has been strong. Against the euro it is only down by 1.8pc. What’s more, the pound is currently positioned just about in the middle of the trading range it has inhabited since the Brexit referendum in 2016.

Mind you, if the Bank lags well behind on interest rate rises, the pound could drop a fair bit further. That would make the Bank’s task of getting inflation back down to target still more difficult. As a rule of thumb, if the pound falls by 10pc, that will tend to push up prices directly by somewhere between 2pc and 3pc, spread out over a number of years.

Yet, as we have seen with regard to the effects of increased energy prices, that is only a part of the process. If the inflationary impulse, rather than being accepted and absorbed, is passed on in the form of higher generalised increases in prices and higher wages, then this one-off jump in the price level can end up as a permanently embedded higher rate of inflation.

For all the criticism of the Bank over recent months – including from me – no one should pretend that its job is easy. The Bank is clearly concerned that the economy is already slowing markedly and that if it raises interest rates too far, too fast, it could tip the economy into recession. Assessing the economy and trying to set policy accordingly is like shooting at a constantly moving target.

This week sees the release of several bits of important economic data that may provide some justification for the Bank of England’s interest rate caution.

Not that there is likely to be any support from the most important set of data, namely Wednesday’s publication of the inflation figures for May. I suspect that the rate may rise from 9pc to about 9.2pc. But I am prepared to be surprised by a higher figure.

I am struck by the fact that in the US, inflation jumped sharply over May and that was surely an important factor in pushing the Fed towards imposing a large increase in interest rates.

On Friday we will get some more clues on the state of the real economy from the release of the latest retail sales figures. I suspect that they will show a sharp fall on the month – the third drop in four months.

On the same day, we will also see figures on consumer confidence, and the same logic applies. They may be very weak. If these figures turn out this way, then this would bolster the Bank’s case for caution and temper the growing criticism of its performance. It badly needs support from somewhere. Its credibility is now severely compromised. This could eventually incur a heavy cost.