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BoE in line of fire over UK’s double-digit inflation

With inflation in the UK hitting double digits, the highest in more than 40 years and the highest in the G7 group of major economies, the Bank of England is in the firing line of politicians and economists.

The British central bank became independent 25 years ago with the mandate to keep inflation at 2 percent. But now there are questions as to whether the officials in Threadneedle Street have lost control.

The team surrounding the conservative leadership’s hopeful Liz Truss is pointing the finger at Andrew Bailey, the BoE governor, and his monetary policy colleagues. In the words of Kwasi Kwarteng, favorite to become the next chancellor: “If your inflation target is 2 percent and you predict 13.3 percent, then something has gone wrong.”

Suella Braverman, attorney general and a key ally of Truss, went on to tell Sky News earlier this month that Truss would look into an upcoming BoE review to see if it was “fit for purpose in terms of its complete exclusive independence.” on interest rates”.

The main argument against the BoE is that it was asleep at the wheel as the economy emerged from the coronavirus crisis. This caused spending to rise too quickly as officials failed to notice the barriers to growth left behind by the pandemic. The result was excess demand and inflation.

Since May 2021, the BoE has been surprised by the strength and continued high inflation every quarter, and this month raised its estimate of peak inflation from 2.5 percent to 13.3 percent. Double-digit inflation is expected to last for a year, well above inflation forecasts for other comparable economies.

Bar chart of annual July CPI inflation (%) showing UK has highest inflation rate in G7

Andrew Sentance, an outspoken former member of the BoE’s Monetary Policy Committee, said the central bank had “acclimatized” people to extremely low interest rates. This, he said, was compounded after the pandemic by the BoE being “so slow to spot some supply-side problems and inflation piling up.”

The verdict is sometimes dismissed within the bank as a hawk who has always wanted tighter monetary policy, but his view is shared by other former officials who are unwilling to publicly criticize the BoE.

A former senior official and MPC member was surprised that the commission had continued with its quantitative easing program, printing money and buying assets in 2021, even though the recovery was much stronger than expected.

Jagjit Chadha, director of the National Institute of Economic and Social Research, said the BoE should have acted more quickly. “They seemed reluctant to say” [interest rates] had to be normalized from such an extraordinarily low level,” he said.

His point was reflected in the regular meetings of a shadow MPC of the right-wing think tank the Institute for Economic Affairs. A majority of its members called for an end to QE in April 2021 and for an interest rate hike in July last year, half a year before the BoE took action.

Line chart of UK CPI inflation (%), with BoE forecasts showing that the BoE has systematically underestimated inflation

But Bailey rejects this criticism. There is growing resentment within the BoE that it is taking the blame for what it sees as largely a global problem over which it has no control.

“I don’t know anyone who can reasonably say they could have predicted a Ukrainian war a year ago,” the governor lamented in the news conference after the BoE told the public earlier this month that a recession was needed to bring inflation down.

The war, along with barriers to global supply chains after Covid-19, were all beyond the BoE’s control, he added, blaming these factors for both high inflation in the UK and the difficult economic outlook.

Bailey likes to note that the BoE was one of the first of the leading central banks to tighten monetary policy when it first raised interest rates in December last year.

MPC members are also keen to highlight what they see as the benefits of an independent central bank that controls inflation.

Jonathan Haskel, an external member of the Interest Rate Setting Committee, went to Twitter with a chart showing that, despite current problems, average inflation in the UK over the past 25 years had almost exactly hit the BoE’s 2 percent target – and this performance outperformed any previous quarter-century going back 800 years.

The UK's best inflation performance over the past 800 years has been the period of BoE independence - UK inflation since 1221 (points indicate averages for 25-year periods between 1221 and 2022)

There were periods when inflation was lower and also when it was close to 2 percent, despite measurement difficulties, but there was no period when inflation was as stable and stable as the period since 1997, when the bank was granted independence.

Haskel’s chart was a modified version of one used by Professor Ricardo Reis of the London School of Economics to demonstrate the benefits of central bank independence and inflation targeting.

But Haskel didn’t mention that Reis’s latest academic papercontaining the chart describes the mistakes he believes all central banks have made since the start of the pandemic, exacerbating inflation.

For now, according to Reis, the challenge is to reduce inflation. Since it is very high, reducing it will involve nasty drugs. This includes “accepting lower levels of real activity”, “taking firm and sharp action with interest rate hikes in the near future” and “repeating as loudly and convincingly as possible the primacy of price stability as the guiding goal of policy”.

Once inflation is way too high, bringing it down is costly, no matter who was to blame.

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