The blinkered Bank of England has missed the economic warning signs. It needs to cut interest rates now
Bank of England Andrew Bailey composite
Amid his countless legal battles, Donald Trump has stirred even more controversy, this time among economists. If re-elected as President of the United States he has stated he will impose a tariff of at least ten per cent on all goods entering the country. What is more, his supporters have told critics of his proposals that they are not inflationary.
Tariffs are paid by firms in the importing country which increases costs for them. They may choose to absorb these costs themselves or pass them onto consumers in the form of higher prices. As such, this would lead to Americans paying more on their weekly shops. This sounds a lot like inflation. However, once the prices have increased they are unlikely to continue increasing on a weekly or monthly basis so in that sense they are not inflationary.
Whether or not we should consider tariffs as inflationary in the traditional sense is in many ways irrelevant. We do know that they do increase the burden on domestic firms which increases their costs. It also means that they face retaliatory tariffs which makes their products less competitive in other countries. All of this reduces trade and hits ordinary working people who have to see their living costs increase and are at risk of losing their jobs.
But it does raise an interesting question for policymakers at the Bank of England: What is it exactly that causes inflation?
The Monetary Policy Committee (MPC) of the Bank has been right to point out that in the UK’s recent experience of high inflation that a number of factors have been at play including Russia’s invasion of Ukraine and disruption to supply chains caused by the pandemic.
These supply side shocks are only part of the story. Perhaps because it would mean the MPC being forced to accept responsibility for its role in leading to high inflation it has repeatedly dismissed the role played by money supply in causing inflation. The great economist Milton Friedman was not quite right when he said that inflation “is always and everywhere a monetary phenomenon”. We have seen that supply side factors definitely do play a role in contribution to inflation. But recent experience has shown that inflation is still driven by the supply of money in an economy.
If the Bank had been paying proper attention to the warning signs then it would have changed course months ago.
As the UK began to open up after the pandemic there was a great deal of pent up demand in the economy, driven by the rapid acceleration in the money supply. The MPC seemed reluctant to acknowledge this and so failed to adopt a more restrictive monetary policy. In many ways this was understandable as it didn’t want to dampen growth at such a precarious point. But this failure to act quickly enough contributed to inflation getting out of control and saw the cost of living rocket, causing misery for millions of people around the country.
The MPC finally decided to act by increasing interest rates and undertaking Quantitative Tightening and it has worked. We have seen inflation start to fall and is projected to return to target and then overshoot it. While this is good news, it has also contributed to the UK economy entering recession and exacerbated the stagnant growth which continues to hit living standards, made it harder for households and firms to borrow, and placed peoples jobs in jeopardy.
If the Bank had been paying proper attention to the warning signs then it would have changed course months ago and started to cut interest rates and not caused so much damage to the economy. The data showed that money supply growth had all but collapsed towards the end of last year and is now near normal levels. Again, the MPC seems to see this as an afterthought in its decision making, preferring to focus on other factors instead. As a result, it has kept interest rates too high for too long and we are all suffering as a result.
You don’t need to be a hardcore monetarist to acknowledge the role played by the supply of money in contributing to inflation. The Bank is right that high inflation has multiple causes but unfortunately it failed to see its importance and so has repeatedly adopted policies which have caused a great deal of damage to the economy and ordinary people. Andrew Bailey and his colleagues need to re-read Friedman and lower interest rates on Thursday.
Ben Ramanauskas is a research fellow at Oxford University and a former government adviser
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