Foreward

The British economy is suffering from a sequence of bleak shocks in its capacity to produce goods and services. These started with the financial crisis, which although international, particularly affected an economy focused on financial services. It continued with the management of the exit from the European Union, which festered and ran like a sore through economic policy. The impact of the pandemic was amplified in an economy so heavily concentrated on the hospitality sector. And as a trading nation reliant on energy and intermediate goods imports, the supply chain disruptions and Russian invasion of Ukraine further exposed the economy to a deterioration in its supply capacity. This fall in productive capacity has left us with one of two options, we accept that on average as a nation we are poorer or, to maintain our level of income, we must increase the hours we work. To be clear these are not the direct concern of monetary policy, which must simply decide following these inflation shocks at what rate to disinflate. These shocks have meant that much of what we buy, which is priced in overseas currency, has gone up sharply in price. The terms of our overseas trade have turned against us and this means that we have to give up more of our production for imports. The sharp increase in traded prices has meant, as with most major central banks, the Bank of England has raised its policy rate rapidly. This is to ensure that the supply shocks do not lead to chronic inflationary pressure. The increase in interest rates has two obvious objectives: first to ensure that once the temporary inflation has abated wage and price setters condition their future rounds of decision making on inflation expectations that are consistent with price stability and second to ensure that demand is brought down in line with a lower level of capacity than was previously thought to be the case. There is though another aspect of the Bank's strategy that is often overlooked. While it is probably true that an earlier response from the Bank might have shaved a percentage point or two off the peak in inflation, the pattern would have been much the same. It is also the case that had a considerably stronger interest rate response been adopted in late 2021 and 2022, it might have stamped on inflation more forcefully, but only by threatening a surge in unemployment and financial disruption in, as we now know, rather febrile markets. The substantive risk of a subsequent deflation was very real. And, following so soon from the tragedy of COVID, that would not have been the right response. The regime change from easy money to normalisation and a shrinkage in the central bank balance sheet, although long heralded, represents a regime shift that ought to be handled with great care. And that is where policy at the other side of town comes in. Double digit inflation is not an outcome anyone wanted, and it is imposing genuine hardship on many families towards the bottom of the income distribution. We have consistently maintained however that it is up to the Treasury, not the Bank of England, to offset the distributional consequences by offering more targeted relief. Our own calculations, published around the time of the Spring Budget, suggested that the inflation tax – in inflating the public purse–has created more than enough fiscal space to support poorer families without generating further excess demand. There is another more subtle point that has been overlooked. The government, by stating a target for halving inflation this year, has inadvertently provided an unhelpful focal point for inflation at some five per cent by the year end. The previous central case was for something well below that and nearer the inflation target. People are now planning at five per cent rather than four per cent or less and this is making inflation more persistent. The government, having set the Bank of England a target for inflation along with operational independence, should not involve itself in forecasting inflation or attempt to take credit for an imminent fall in inflation. Recall that the 'control of inflation' job, which involves forecasting and deploying instruments of the open market and open mouth kind, was handed over to the Bank in May 1997. This year the government has itself made the Bank's job harder by saying it will get inflation down. The chairman, having picked the manager, should not try to take any last-minute penalties. The question then is: if he does take that penalty, is it a case of bad luck when he misses?