Missing the surge in inflation

BoE Governor Andrew Bailey

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The UK House of Lords Economic Affairs Committee has helpfully just published a review into the Bank of England and it has suggested a number of mistakes that need to be put right. But the BoE, like most other central banks, will probably say the equivalent of ‘thanks, but no thanks’ when it comes to taking any such recommendations on board.

The Committee highlighted a number of failings in its review of the Bank. It argues that the remit of the Bank is too wide, its economic models are no good, it is not sufficiently diverse and it ignores what is happening with the money supply. This might be a criticism of the Bank of England, but with other central banks failing to spot inflation as well, is it a critique that can be levelled at all central banks? Possibly.

Many of these things do seem common to central banks, such as a widening of the policy remit. On this note it is interesting that in New Zealand the incoming government is removing the Reserve Bank’s target for employment that was introduced by the previous government. When the remit is changed the Bank will go back to focussing on inflation first and foremost. Hence there might already be a bit of a backlash against wider mandates. The economic models used by the BoE, of the Dynamic Stochastic General Equilibrium (DSGE) type have been popular with central banks for decades. But they struggle when major shocks occur, which is, of course, what we have seen in recent years.

The alleged lack of diversity amongst Bank of England members is also a criticism that we hear quite widely and many central banks have been trying to take steps to address it (but arguably not the Bank of England). Finally, with respect to monetary growth, this too is a critique that could be levelled at most central banks as there was a common surge in annual growth rates in 2020 and 2021, followed by an equally spectacular fall thereafter.

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But would such changes have avoided much of the surge in inflation that has been seen in the UK and elsewhere in recent years? Probably not. Mr. Steve Barrow, Head of Standard Bank G10 Strategy said the magnitude of the inflationary shocks coming from the damage to supply chains during Covid, and the surge in energy prices following Russia’s attack on Ukraine would have overwhelmed any central bank with any remit, any diversity, any models and any focus on monetary growth. It was simply bad luck. This being said, if there is a more valid criticism, it is that central banks had a mistaken belief that they had essentially conquered inflation prior to the pandemic. But rather than the low inflation in the pre-Covid period being down to the good work of central banks, it was simply a period of good luck. This good luck was primarily due to rampant globalisation, spurred first and foremost by China’s industrialisation and accession to the WTO. This caused massive disinflationary pressure that central banks largely mistook as being due to their own anti-inflation credibility.

Even today many central banks still try to argue that inflation expectations are ‘anchored’. But the problem is that they might be anchored but public confidence in central banks is on the floor (as the Lords Committee noted in the case of the BoE). Put more simply, if a person is asked, where do you think inflation will be in 10-years’ time, and they say 2%, it matters a great deal whether they have confidence in the central bank to deliver. Right now, the public seems to have no confidence. This confidence will only come back if, and when, inflation targets are achieved and this, in turn, is a clue that central banks won’t go soft on inflation and start to ease well before inflation hits the target.

“The market seems to believe otherwise, probably because central banks appear to have folded in the past when the economy has suffered. But the stakes are much higher right now and this talks to the view that if central banks do not meet market expectations with rate cuts it will be because they have waited longer to act, not jumped the gun”, said Mr. Steve Barrow.