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Why criticism of the Bank of England is largely misplaced

The writer is a British economist at Morgan Stanley

With inflation higher than it has been in decades, there is no shortage of critics of the Bank of England. Yet most of the blame seems largely unfounded.

The BoE has been criticized for being too slow to raise interest rates and doing too little since then. But the central bank had a particularly bad macro hand to play.

An earlier, tighter policy regime would have had only a limited effect on dampening current inflation, and under the circumstances, the BoE’s monetary policy stance could be the best choice among a range of difficult options.

According to our forecasts, higher food and energy bills will directly account for 60 percent of the expected peak inflation figure in October. Non-core inflation is not something that can influence monetary policy.

In December last year, the BoE made the point that, given the monetary policy slowdowns, in order to deal with a rise in imported inflation, even before Russia’s invasion of Ukraine, it would have had to begin quite aggressive policy tightening for as far back as it was during the first wave of the pandemic in early 2020. That was just as the UK economy was about to be battered by a contraction of nearly 20 percent per quarter due to the initial lockdown.

Implementing such tight policies may have limited inflation to the BoE’s desired target of 2 percent by early 2022, but unemployment could shot up with about 800,000 jobs, according to the central bank’s models.

In fact, compared to its peers, the BoE’s response was quite timely. As early as September last year, it acknowledged that inflationary pressures may not be transient; and in February it had raised interest rates twice and announced the beginning of its balance sheet reduction. In stark contrast, the Fed and the ECB were still buying assets as part of their QE programs.

Even the tightness in the UK labor market is probably more of a demand than supply story. Employment is still well below its pre-covid peak – with 210,000 jobs – and the labor supply declined by 290,000 workers in May.

In addition to the reduced influx of migrants, the lower domestic participation is also a problem. For example, the UK has never had so many potential workers outside the labor market due to health problems. The BoE may affect labor demand by slowing growth, but there’s nothing it can do to shorten the NHS’s waiting lists.

Line chart of policy rates (%) showing BoE was the first to raise rates among its direct peers

Moreover, the relatively lackluster recovery in the UK after the pandemic belies the argument of monetary policy-driven inflation. Business investment growth has been very subdued and consumption growth is now also slowing, despite the simplistic reading of the real interest rate of 8% negative, taking into account the inflation forecast for August.

Instead, it could be argued that a Brexit-related reorientation of EU imports is a possible culprit of rising prices. Inflation of goods manufacturing in the UK was more than 4 percentage points higher than in the euro area at its recent peak. Even the conventional view that only higher rates can support the currency, and thus dampen inflation on imported goods, was overturned last week when the sterling exchange rate fell after the BoE’s bold 0.50 percentage point gain, while traders concentrated on weakening growth.

Faced with a more difficult trade-off between employment and inflation than for other central banks, BoE action has been largely gradual in the first half of this year. Since it forecasts a medium-term inflation rate well below 2 percent, there is an argument that the current peg in bank interest rates has already reached levels consistent with the BoE’s mandate to control inflation over time. to be reduced to 2 percent.

With heightened near-term inflation expectations and another imported inflation shock looming as gas and electricity prices are set to rise again in October and January, the Monetary Policy Committee took a more firm stance last Thursday. Raising interest rates by 0.50 percentage points amid a protracted recession forecast shows that the MPC intends to act against any inflationary pressures.

So, what about potential tax policies then? In our view, fiscal measures should target low-income households, which have seen relatively weaker wage growth to date and are likely to have little to no excess savings from the pandemic. Such targeted support would protect the most vulnerable while having a limited impact on inflation.

Reducing labor supply shortages can also lower inflation, so supporting the NHS in reducing waiting lists more quickly is a good option. The BoE has a difficult task and no easy policy choices. Fiscal policy should not complicate the Bank’s already challenging task.

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