The economy risks falling victim to the Bank of England’s blind spot
Interest rate expectations are becoming like the Grand Old Duke of York, marched up to the top of the hill one month, only to be marched back down again the next.
We seem to be at the “neither up nor down” point right now. Confusion reigns supreme, with the Bank of England’s signalling all over the place.
There’s a good reason for this lack of clarity. One minute it looks as if Western economies are heading into recession, the next that they are not. Then all of a sudden, perceptions change again. Last autumn, a hard landing looked almost certain. A red hot labour market report from the United States and a raft of encouraging survey data from Europe has since changed that judgment.
According to the European Central Bank, a recession can now be ruled out. In Britain and beyond, things seemed to be looking up. Market interest rates have risen accordingly, but with little in the way of conviction. Which way should we be facing?
In a speech last week, Andrew Bailey, Bank of England Governor, seemed to suggest that markets were getting ahead of themselves in believing that the current tightening cycle still had a way to run. Ergo, the peak for Bank Rate may be soon.
However, some commentators confusingly took the opposite meaning from his remarks and concluded that he had just turned a tad more hawkish. It was possible to read both messages into Bailey’s “on the one hand this, on the other hand that” speech.
The truth is that he doesn’t know himself. The evolving data will determine the outcome, he insists, but this is proving as all over the place as he is.
One thing is for sure. You don’t have to side with Citigroup – which is an outlier in this regard, predicting that UK inflation will be back down at close to its 2pc target by the end of the year – to know that it will soon be falling.
Rapidly declining commodity prices – particularly energy costs – mean that base effects alone will weigh heavily on the overall rate of inflation. Shipping costs have also fallen dramatically just at the point when, newly released from self-imposed Covid imprisonment, Chinese factory output is once again breaking new records. Supply of goods is surging into Western economies where real incomes are shrinking and the servicing costs on mountainous debts are rising strongly.
Until very recently, I’ve tended to be on the hawkish side of the inflation versus deflation debate. That view was fully vindicated by last year’s dramatic upswing in prices into double-digit territory. But nothing is forever and there comes a point when inflation becomes yesterday’s story. For me that point is fast approaching. In particular, I’m persuaded by the so-called monetary aggregates, which have been contracting for some time now. Very little understanding of complex economics is required to see that inflation is above all a consequence of too much money chasing too little supply. “Inflation”, as Milton Friedman said, “is always and everywhere a monetary phenomenon”. It’s simple common sense.
Yet bizarrely, the quantity of money is scarcely ever mentioned by the Bank of England, or indeed the US Federal Reserve and the European Central Bank, and there is little evidence of it influencing their thinking. In failing to take it on board they hopelessly misjudged last year’s sudden spike in inflation.
Admittedly, quite a bit of that surge was down to Putin’s assault on Ukraine, which caused energy prices to skyrocket. But a significant element, possibly even the majority of it, was simply a question of too much money and too little supply.
It should be central banking 101 that if hoping to keep the lid on inflation, you do not react to a negative supply-side shock with measures that increase demand, yet this is precisely what the Bank of England has been doing ever since the vote for Brexit, nearly seven years ago.
This basic misjudgment reached its crescendo during the pandemic, when the Bank of England engaged in another great splurge of money printing into an economy that had just suffered a profound hit to supply. It was a similar story with the Fed and the ECB. We can excuse from this criticism the quantitative easing (QE) that immediately followed the global financial crisis. At that time, central banks were merely compensating for the destruction of money in the banking sector, where credit was being squeezed on a heroic scale.
That has not been the case in the more recent bursts of QE, where the story has been one of new money injected on a massive scale into a system already awash with it.
Fast forward to now and we are seeing the reverse phenomenon. In a classic case of slamming the door long after the horse has bolted, central banks are tightening into an economy where money is already contracting.
With the public finances turning out better than anticipated, we can expect some easing of the fiscal thumbscrew from Jeremy Hunt, the Chancellor, in the Budget later this month. It now seems likely, for instance, that the typical household energy bill will remain capped at £2,500, rather than being allowed to rise to £3,000 as planned. But it is the monetary environment, not the fiscal one, which is ultimately going to make the difference between an economy that is expanding and one that is contracting, and right now, according to Simon Ward, economic adviser to Janus Henderson, it is pointing unambiguously towards the latter.
Monetary trends, he points out, warned of worse than expected outcomes in 2008 just ahead of the financial crisis and are giving an equally negative message today.
It has been argued that monetary aggregates of this type mean little in today’s fast-moving world of digital money. The surge in money up until the middle of last year was, moreover, so massive that it may have created an overhang that cancels out today’s contraction. So massive, in fact, that the ratio of money to GDP is not yet back to where it was just ahead of the pandemic, Tim Congdon, another monetarist, points out.
All the same, it would go against all past precedent if today’s monetary tea leaves turned out to be completely wrong. In any case, their recessionary implications are backed by a number of market indicators, most notably, the steepest US “inverted yield curve” – where the yield on short-dated US Treasuries is greater than the long-dated version – in 42 years.
Bailey’s indecision is understandable against such a backdrop. Yet even the Bank’s own forecasts point both to inflation dropping below target next year and a recession with rising unemployment, and that’s without any apparent reference to the money supply at all. Bailey will likely be marching interest rates back down the hill again sooner rather than later.
But in the meantime, the Bank’s blind spot for the obvious will have inflicted untold harm on savings, investment, employment and much else besides.
‘Inflation is a result of too much cash chasing too little supply. Yet the quantity of money is scarcely mentioned by the Bank’