Why the Bank of England must hike rates now
Britain’s inflation has taken off but the Bank of England appears to be ignoring the influence of monetary trends. This failure could be dangerous.
The root cause of our inflation has been the development of an excess supply of money relative to the economy’s demand to hold liquidity. An attempt by consumers and companies to eliminate this surplus has contributed to the pick-up in nominal spending; excess liquidity may also have made it easier for firms to pass on cost increases.
Most economists with monetarist leanings have dismissed the possibility of such an imbalance because of the slow pace of broad money supply expansion in 2008-09. The surplus, however, is the result not of an excessive rise in supply but rather a fall in demand: negative inflation-adjusted deposit account rates have encouraged investors to rebalance portfolios away from money into assets offering higher yields and inflation protection.
To the extent that the possibility of a decline in money demand is acknowledged, the consensus is that this represents a one-off shift, implying no lasting implications. Such a view, however, is at odds with experience in the 1970s, when a fall in the ratio of money to national income was sustained for several years as the authorities, as now, maintained interest rates well below the rate of price increases.
Meanwhile, the Bank’s favoured broad money measure, M4 excluding holdings of non-bank financial intermediaries, rose at a nine per cent annualised pace in the three months to May. The consensus is that this supply pick-up will, again, prove temporary because bank lending to the private sector remains weak. Money and lending, however, can diverge significantly. Eurozone worries, an undervalued exchange rate and the coalition’s action to tackle the deficit may result in a sustained inflow of foreign capital into the UK. A combined surplus on the current and non-bank capital accounts of the balance of payments will expand the money supply relative to private sector lending – and hence create a gap between these two variables. Recent strong foreign buying of gilts and Treasury bills could be an early indication of such an inflow.
An early rise in rates is warranted, not to choke off the growth in the UK money supply but to boost demand for money to eliminate surplus liquidity. Higher rates would increase the UK’s attractions to foreign investors, with capital inflows likely to put upward pressure on the exchange rate.
It’s time for the MPC?to act to tackle our inflation problem. Simon Ward is chief economist at Henderson Global Investors