Why the Bank of England looks unusually hawkish
TIL BANK OF ENGLAND is an outlier. Investors expect interest rates to rise before the end of the year, then to 1% by August 2022, faster than the European Central Bank or the Federal Reserve (see graph). It might even start doing so before it completes its bond buying program, known as quantitative easing. The executives of the bank feel in an exceptionally delicate position. Ben Broadbent, deputy governor and member of his monetary policy committee for a decade, says it is “the most difficult time for monetary policy I have ever seen.”
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Some of the discomfort is shared among central banks. After the outbreak of the covid-19 pandemic, core inflation did not drop as much as expected as supply struggled to keep up with seismic shifts in demand. More recently, boomed supply chains and energy shocks have kept prices at a sustained level. The UK consumer price index rose 3.1% in September and the Bank of England expects it to surpass 4% later this year. At the same time, in September, annual inflation climbed to over 5% in America and 3.4% in the eurozone.
Policymakers insist that these pressures will subside. But with inflation expected to persist until next year, the risk is that people will start to factor it into their wage demands, causing prices and wages to spiral upward. The chances of this happening depend on the underlying strength of the real economy, about which there is little certainty. If policymakers overestimate its strength and contract credit too quickly, they will hurt it more. If they underestimate its strength and offer loose credit terms for too long, they risk exacerbating an inflation problem.
Given the circumstances, one would expect the Bank of England to be on the cautious side of the spectrum. The IMF predicts that the US economy will be larger in real terms this year than it was in 2019, while Britain’s will not reach that milestone until 2022. He also expects the British government is tightening its fiscal policy faster than America or the Eurozone. Rishi Sunak, the Chancellor of the Exchequer, trumpeted his rectitude ahead of the October 27 budget. As he put it: “Racking up bills that future generations must pay is not only economically irresponsible, it is immoral.
It is possible that investors are overestimating the hawkishness of the Bank of England after a decade of doing just that. The recent wave of confidence that a rate hike is expected came after an October 17 speech by Andrew Bailey, the Governor of the Bank of England, in which he said “we will have to act”. But he added that the action would only be in response to “a risk, especially of medium-term inflation and medium-term inflation expectations“. He did not specify that these conditions were met.
A lack of UK labor market data following the withdrawal of pandemic wage support makes it unlikely that the Bank of England will raise rates as early as November. But, despite the bank’s confusing communications strategy, the global hawkish slant is clear. Notably, Mr. Bailey chose not to push back rising expectations of an upcoming rate hike.
One of the reasons Britain might move away from its rich world peers is because it has suffered the double whammy of the pandemic and Brexit. The combination makes the health of the economy difficult to decipher, prompting caution. But the additional damage can also accelerate the point where core inflation becomes an issue.
A decision to raise interest rates would reflect credibility issues. As a smaller and more open economy, Britain is particularly vulnerable to shocks. Investors’ expectations of inflation over the next five years have accelerated. Household inflation expectations for the next five to ten years are at their highest since 2013.
Inflation expectations have also risen in America and the Eurozone. But the political context is different. The Fed and the European Central Bank both see the 2010s as a period when monetary policy was too restrictive and inflation expectations too low. Both have updated their anti-inflation frameworks to allow inflation above 2%. The Bank of England has come very close to its target and therefore has not revised it. This leaves policy makers more worried about any overshoot. In other words, the Bank of England is a victim of its past successes.
The political mood in Britain further complicates matters. In July, the House of Lords’ select committee on economics berated the bank for its lack of transparency regarding post-pandemic bond purchases. Its bond buying schedule was surprisingly similar to that of the Treasury for bond sales, raising suspicions of blurred lines between monetary and fiscal authorities. If outsiders start to believe that the Bank of England is more interested in supporting the Treasury than curbing inflation – of which there is no strong evidence to date – it would exacerbate the credibility problems.
Everything barks, no bite
Warmongering gossip can be a ploy to persuade markets to do the Bank of England’s dirty work. If investors think monetary policy will tighten, then credit conditions in the real economy will tighten regardless of what the bank actually does. On October 14, Catherine Mann, a member of the monetary policy committee, suggested that the increase in long-term interest rates reduced the need for rate setters to go all the way.
Many skeptics do not believe that nothing more than harsh speech is justified. High household inflation expectations haven’t translated into wage increases for at least 15 years, according to Samuel Tombs of Pantheon Macroeconomics, a research firm. Andrew Goodwin of Oxford Economics, another research house, says that aside from a few small sectors making headlines, the story of much of today’s job market is actually a glut of workers.
British monetary policy makers could also find it difficult to tackle the global forces that have driven interest rates down over the past two decades, says Dario Perkins of ST Lombard, a research team. “Every time a central bank has tried to get out of this over the past 20 years, it has ended up having to reverse it,” he notes. Investors can expect the monetary policy committee to fend for itself, but it would still be a bold move. ■
This article appeared in the Great Britain section of the print edition under the headline “Ready for a leap in the dark”