The Bank of England’s response to the uncomfortable dilemma of stagflation will be a key test of its credibility
The Bank of England faces an uncomfortable time over the next couple of years, if its latest forecasts turn out to be broadly correct.
The latest projections in the Bank’s Inflation Report published yesterday show that inflation will be pushed up by the fall in the pound and is likely to remain above the 2 per cent target – not just in the short term, but until the end of 2019. Even though it will not rise as high as in 2008 and 2011, when CPI inflation hit over 5 per cent, the Bank’s Monetary Policy Committee (MPC) is now expecting a more sustained rise in inflation than in its last forecast in August.
Meanwhile, growth is expected to be subdued – not just next year but in 2018 and 2019 too. In the past 12 months, GDP rose by 2.3 per cent in the UK, and across the recovery which has been underway since 2009, growth has averaged around 2 per cent. The latest Inflation Report suggests a central forecast of around 1.5 per cent growth in 2017, 2018 and 2019 – a prolonged period of disappointing economic activity.
These forecasts do not look unrealistic. The uncertainty created by the EU referendum decision is likely to affect business investment negatively to some degree. This drag on investment is quite likely to persist while the Brexit discussions are ongoing – i.e. until 2019.
The kind of long-term investment decisions which might be affected by the uncertainty about our trade relationship with the EU will not impact capital spending overnight – but may do so over a period of two to three years.
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Our experience after the financial crisis was also that a big fall in the currency can contribute to a prolonged surge in inflation. Currency hedging and forward purchasing limit the inflation impact of a fall in the pound in the very short term, but they cannot forestall it indefinitely. So the notion that we might expect a prolonged period of above target inflation also seems realistic.
When higher inflation and weak growth emerged in the 1970s, it was labelled stagflation. The rise in inflation the Bank is now expecting is much less extreme than the double-digit inflation which we experienced 40 years ago. And while growth is disappointing, 1.5 per cent is not a disaster compared to the trend of around 2 per cent we have experienced so far over the recovery. The Bank expects the unemployment rate to rise to around 5.5 per cent – not far from the level of just above 5 per cent seen before the financial crisis.
But even though the combination of weak growth and higher inflation is not a dramatic shift in the outlook, it still poses the same dilemma for monetary policy that we experienced in the 1970s. Does the MPC respond to the disappointing outlook for growth and hold down interest rates? Or does it react more strongly to head off the risk that higher inflation becomes embedded?
In my view, the MPC’s reaction to this dilemma has to be influenced by the level of interest rates we are starting from. The fact that interest rates have been so low for so long, and that they were reduced even further over the summer, creates a need for a longer-term normalisation of monetary policy.
The very persistent low level of interest rates since 2009 is starting to have damaging impacts on the economy – by discouraging savers and inflating pension fund deficits. It is important that central banks like the Bank of England take these adverse long-term effects into account. We need monetary policies which sustain the long-term health of the economy – not just a firefighting response to the latest economic crisis.
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With its Forward Guidance, the Bank of England appeared to recognise the need for higher interest rates from 2013 onwards, but it never got round to implementing the first interest rate rise. And when Brexit loomed large, the MPC cut interest rates instead.
If the MPC never responds to the risk of inflation and always prefers to relax policy rather than tighten it, its credibility will be damaged and confidence in its policies will be gradually undermined. So the way in which the MPC responds to the current growth and inflation outlook will be a key test of its credibility and independence in the years ahead.
A prolonged period of higher inflation – which the Inflation Report is now forecasting – should at some point require a response in the form of higher interest rates.