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The writer, an FT contributing editor, is the chief executive of the Royal Society of Arts
The consensus surrounding UK inflation and interest rates has become increasingly loud lately. Economists, financial markets, commentators, and politicians are all convinced that UK interest rates must continue to rise in order to control rising prices. The Bank of England, with its recent 50 basis point rate increase and accompanying messaging, is leading the charge.
The latest UK inflation figures explain the urgency, as headline inflation remains higher than expected and core rates rise to levels well above those of other countries and target levels. Many believe that the Bank of England had no choice but to raise rates and will continue to do so until inflation is completely subdued, as Chancellor Jeremy Hunt stated. Not raising rates would have jeopardized the credibility of the bank.
However, there are valid reasons to be skeptical of this consensus. Many of these same individuals failed to predict the initial rise in inflation. Now, they interpret every inflation miss as a significant problem. This reactionary approach risks overcorrection and mirrors the actions of a late convert.
The higher and persistent inflation in the UK likely reflects more acute supply shortages, especially in the labor market, compared to other countries. These constraints are responsible for increasing prices on an ongoing basis. In this situation, the conventional role of monetary policy is to tolerate these temporary inflation misses as long as inflation expectations remain stable. Not doing so would further harm economic growth.
The UK economy cannot afford this scenario. Growth is stagnant, and households and businesses face multiple challenges. Already burdened by rising living costs, they are about to experience higher borrowing costs. This means that approximately 3.5 million mortgaged households will see their incomes fall by more than 8%, not to mention the 4.6 million renters who will also be affected if their landlords have mortgages.
Considering that a quarter of UK households have little to no savings, this situation may lead to a disproportionate decrease in spending and ultimately result in job losses. Past tightening of monetary policy is about to harm the financially vulnerable. For the UK, this could lead to a recession.
However, there is an alternative approach. Despite the rise in headline inflation, expectations remain stable. Cost and price pressures are expected to diminish in the second half of the year. Under reasonable projections, inflation would reach 3-4% in a year’s time without any further tightening. At these levels, it becomes questionable whether squeezing out the last drops of inflation at a faster rate is necessary.
Inflation no longer has a significant impact on public consciousness at 3-4%. Therefore, the costs of lowering inflation by those extra percentage points, measured in terms of lost incomes and jobs, outweigh the benefits. The Phillips curve begins to flatten, and squeezing out the final drops rapidly would result in sacrificing thousands of jobs for minimal gain.
One could argue that tolerating above-target inflation for a slightly longer period overlooks the mandate to maintain the inflation target. However, the existing framework and the open letter system provide the Bank of England and the Chancellor with the flexibility to extend the timeline for returning inflation to target. In fact, this flexibility was built into the system for circumstances exactly like the present one. The peculiar part is that it isn’t being utilized.
Using this flexibility would allow the bank to pause and assess the situation, providing a smoother path for borrowers and reducing the risk of a recession caused by policy. Other options, such as relying on lenders as proposed by both major political parties, are better than nothing but are clearly less effective than addressing the issue at its root.
Imagine a doctor who, uncertain about the nature and severity of a disease, administers a large dose of medicine that has yet to take effect. Prudence dictates that they pause to observe the patient’s response before increasing the dosage. Central banks should abide by this principle now to avoid overdosing the economy.
Over a decade ago, the UK implemented fiscal austerity measures in an attempt to reduce debt. However, this decision hindered growth and proved counterproductive for debt reduction. Similarly, current monetary austerity measures aimed at reducing inflation risk the same consequences. It is time to redirect the stampeding herd away from the edge of the cliff, for the sake of financial security and the credibility of our policy institutions.
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