Is the Bank of England’s plan to tame inflation working?

At the end of June, Bank of England made its 13th rate hike, a 0.5 percentage point rise to 5 per cent.

While borrowers might be struggling, it’s the central bank that’ll be feeling unlucky as the tried and tested orthodoxy of raising rates has done little to bring down inflation. 

Ahead of the next base rate decision on Thursday, the bank will be relieved the most recent inflation reading showed headline inflation has started to ease.  

Andrew Bailey has hiked rates to a 15-year high but inflation remains at elevated levels 

However, core inflation is proving to be more ‘sticky’, having risen to 7.1 per cent in May and slipping back to 6.9 per cent last month.  

Markets are now pricing in rates to peak at 6.25 per cent by the end of the year, leading many to question just how well Andrew Bailey’s plan is working.

Other countries have seen inflation start to ease, but many economists are now saying the UK has an inflation problem even as the Bank continues to drive up the base rate to a 15-year high.

Is the BofE’s plan to bring down inflation working?

When inflation hits such high levels, the central bank tends to think consumers have too much money to spend. 

The accepted orthodoxy is that raising the base rate helps to drive up the price of borrowing, giving people less money to spend and therefore bringing down the inflation rate.

The idea is that borrowers will cut more of their spending, while savers, who tend to be older, won’t spend nearly as much.

However, inflation has remained elevated ever since the Russian invasion of Ukraine prompting discussion that raising rates might not be as effective as it has been in the past.

One of the difficulties is that current inflation is driven more by various supply-side issues and demand shifts rather than huge increases in aggregate demand.

Does this mean the Bank of England’s toolkit is largely redundant? Not quite. 

David Page, head of AXA IM’s Macro Research team says: ‘It’s not obvious that we are materially facing something that’s greatly different from the 1970s.

‘We’ve seen a huge energy shock that was not predicted and came effectively out of nowhere… That’s exacerbated a tight labour market and we’re seeing inflation expectations rising.

‘These are all of the ingredients to varying different degrees as to what we saw in the 1970s.’

The problem is not so much the tool the bank is using but the current situation the UK finds itself in, meaning it is taking much longer to filter through to the real economy.

Pantheon Economics recently said: ‘We still retain faith in the wide range of leading indicators which suggest that labour market slack will emerge and consumer price and wage increases will slow over the coming months.’

Why are rate raises taking so long to filter through to the economy?

While headline inflation might be slowly easing, the Consumer Prices Index (CPI) remains a long way off the BoE’s 2 per cent target. And it’s expected to take much longer to return to normal levels than other countries, too.

Ruth Gregory, Capital Economics’ deputy chief UK economist said: ‘Inflation in the UK has stayed higher than elsewhere as the UK has endured the worst of both a big energy shock (like the eurozone) and labour shortages (even worse than the US). Admittedly, the upward influence of the energy supply shock is fading.

‘But the tighter labour market will probably mean that UK core inflation stays higher than in the US and the euro-zone until late-2024.’

It’s important to note that there is always a lag when it comes to monetary policy – the BoE itself says it can take up to two years for it to have a full effect on the economy.

Bailey’s letter to Hunt following the most recent rate rise said: ‘The MPC recognises that the second round effects in domestic price and wage developments generated by external cost shocks are likely to take longer to unwind than they did to emerge.’

The problem lies more with UK-specific issues that mean there is a longer lag than usual between implementing monetary policy and its effect on the economy.

The first is the shift in the structure of the housing market. Just 30 per cent of households have a mortgage, while 35 per cent own their home outright and the other 35 per cent rent. 

Bailey has said this trend means ‘the transmission of monetary policy is going to be slower as a result’.

Ashley Webb of Capital Economics says: ‘The big shift from variable rate mortgages to fixed rate mortgages since the Global Financial Crisis and the rise in the number of homes owned outright means that fewer people are being affected by higher mortgage rates than in the past.’

Page adds that the way households, and to some extent corporates, hold debt has changed. ‘We see much more fixed rate mortgages and where we have [them], they tend to be a slightly longer tenure. So rather than two years, they’re now more likely to be five years.’

This might soon wane as some 1.4million are seeing their fixed rate deals come to an end in the coming months.

Webb says: ‘As households’ fixed-rate mortgage deals expire they will soon have to refinance at a higher rate. Higher interest rates will reduce demand as households will have less disposable income to spend on other goods and services. In other words, higher interest rates will soon bite harder.’

In a recent speech, Silvana Tenreyo, the outgoing Monetary Policy Committee member, also said: ‘The majority of the effect of the large and rapid policy tightening so far on mortgage rates has not yet occurred, as indeed is the case for the overall impact of monetary policy on inflation.

Another difficulty is that monetary policy tightening has been offset by significant fiscal stimulus in recent years.

The pandemic helped households build up a degree of excess saving, creating a buffer for many households to rely on when prices rise.

‘Certainly some households [and] some corporates have been able to weather the increase that we’re seeing coming through inflation, but also the increase in interest rates by just reducing some of the spare cash they’ve got kicking around, and they’ve still been able to spend as nothing nothing else has changed,’ says Page. 

‘So that buffer is to some extent slowing the impact.’

Other government help, like the energy price guarantee scheme, have also helped to offset the impact of inflation on consumers. 

‘The bank is basically trying to withdraw cash from the economy to slow economic activity,’ says Page. ‘At the same time, the government is very mindful of the impact this is having on households and has been giving cash back to the economy.’

A reduction in labour supply since the pandemic, either because of general recruitment difficulties or a higher number of those off-sick, are tightening the labour market and keeping wage growth high, too.

How long is the monetary policy lag?

The circumstances are not ideal for the BoE but higher inflation doesn’t seem to be terminal. Instead, it will just take more time for savings to start to wane and mortgage rates to feed through. 

Page says: ‘We would normally have expected to see a total economic impact over 18 months to two and a half years. And that looks like it’s being pushed back. Certainly [now] it’s more towards two and a half to three and a half years.’

A lot of the uncertainty comes through the structure of the housing market. Many people will now be looking to increase payments, extending terms and some may even move to interest-only mortgages.

AXA IM’s David Page says the BoE’s rate hikes will take some time to filter through

‘It looks like homeowners are going to see the squeeze coming through less quickly for any given increase in interest rates than would have been the case previously,’ says Page.

‘It’s hard to put an exact number of months on how long historically it’s taken and how much longer it’s likely to take this time, but it evidently is taking a reasonable amount longer. I think an estimate of perhaps six months to a year more, to see the effects coming through is plausible for now.’

The BoE will be mindful that if they over tighten the economy will be on the path to risk and Page warns it would take longer to stimulate the economy.

‘This extended lags works both ways. So it takes longer to tighten monetary policy and have that be effective on the economy. The reverse would also be true, obviously, at this stage when we’re looking at trying to contain inflation that’s not a worry, but it might become the worry over the next couple of years. ‘

What other options does the bank have?

The bank is under pressure to pause rate hikes, amid market expectations the base rate will rise to 5.25 per cent this week. 

There are fears that Bailey, who has faced criticism for letting inflation reach their highest levels in decades, could now go too far the other way, plunging the economy into recession. 

There are some other tools the bank can use to bring down the headline rate.  

It could use quantitative tightening, which is when it sells of its accumulated assets (mainly bonds) in order to reduce the supply of money circulating in the economy.

It requires striking a balance between removing money from the system without destabilising financial markets. If the BoE were to remove liquidity too quickly, it could spook markets.

‘Theoretically, [the BoE] could use QT but it has very little confidence in the direct pasture of quantitative tightening to impact the short-term inflation profile and probably wouldn’t want to use that as a tool,’ says Page.

‘It also has a tool of macro prudential tightening, which theoretically could have an impact but again, it reserves that for financial stability and likes to have a sort of clear segregation of tools to goals, which is appropriate.

‘So within the central bank’s toolkit, interest rates are still the most appropriate and will still be used, but the government could be doing more to help as well.’

Fiscal tightening could help to slow economic activity by increasing the pain for households and corporates in the short term.

Former MPC member Kate Barker has called on the government to hike taxes to tackle inflation. 

She told the FT: ‘We attributed too much power to monetary policy. You could argue that the same thing’s happening today. We’re asking monetary policy to do all the work.’

Page says that while ‘tax policy isn’t the most efficient way of managing the economy… at a time where interest rates are struggling… you could supplement that with fiscal policy.

‘The government could use the opportunity to increase taxation or cut spending, repair the government finances a little bit but at the same time, take some of the pressure off of the Bank of England, doing all the heavy lifting in terms of inflation.’

This post first appeared on Dailymail.co.uk