The Bank of England must have the courage of its convictions

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At this stage of the inflationary process, the central bank needs to show moral strength. The Bank of England’s 0.5 percentage point increase in the intervention rate last week was undeniably necessary. It may also happen that the resulting 5 per cent rate is not peak. Nevertheless, doing whatever it takes to bring inflation down to the target is more than just desirable, it is the bank’s legal duty. No one in the Monetary Policy Committee is free to ignore this obligation.

So far it is also impossible to hold on to the notion that what is going on in Britain is nothing more than a temporary bout of imported inflation. In the latter there was always the possibility of starting an inflationary process. So, in fact, it has happened. In the UK, annual core inflation (which excludes food and energy prices) was 7.1 per cent in May, services inflation was 7.4 per cent and the three-month moving average annual growth of private sector wages (excluding bonuses) in April was . as high as 7.5 percent.

Such a rate of wage growth is not surprising. In April, real average weekly earnings were 4 percent below the level two years earlier and at the same level as in August 2007. The unemployment rate in the first quarter of 2023 was also only 3.9 percent. This indicates a very tight labor market. Under these circumstances, why would one expect that workers would accept large cuts in real earnings? Also, the current rates of wage inflation are clearly inconsistent with 2 percent inflation.

Something has to change, radically and quickly. We are seeing price-price and wage-price spirals throughout the economy. The only way to stop this is to remove favorable demand. In other words, the question is not whether a recession will happen or not; it is rather whether there Requirements There has to be one, if the spiral is to be stopped. The plausible view is that the answer to the latter half of this question is “yes”. Whether you like it or not (I certainly don’t), the economy will not return to 2 percent inflation without a sharp recession and high unemployment.

This gives rise to four questions.

The first is whether the current monetary policy is tight enough. The argument could be that after a long period of ultra-low rates, borrowers are highly sensitive to higher nominal interest rates. In contrast, a nominal rate of 5 percent today means a lower real rate. Loan 2 percent. Moreover, the squeeze will come quite slowly. According to Financial Conduct AuthorityIn the second half of 2021, 74 percent of mortgages were at fixed interest rates between two and five years. Overall, rates may have to go up again.

The second is whether the government should soften the blow to borrowers. Answer: Absolutely not. There’s a reason people with big debts tend to be relatively affluent. Torsten Bell of the Resolution Foundation explains, Targeted assistance to the most vulnerable is the right policy. The second reason is that it would defeat the very purpose of the exercise to strengthen demand. If fiscal policy is to compensate, monetary policy will have to be even tighter than it would otherwise be. If there is a desire to reduce monetary pressure, fiscal policy must be tightened, not loosened.

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The third is whether the uncertainty surrounding all these decisions should encourage extreme caution in exercising them. Unfortunately, it is not that simple. True, much uncertainty exists about the strength of underlying inflationary pressures and how deep an economic downturn is needed to bring them under control. Similarly, there is a lot of uncertainty about how much stringency is needed to bring about such a slowdown. But if one is committed to getting inflation back on target in the near future (i.e. less than two years), it would be a trivial mistake to err on the side of optimism about how easily inflation will fall, which is untrue. . Reducing now will reduce recession. But, if it fails to bring about the necessary decline in inflation, an even bigger recession may be needed later, when inflation will be still more severe.

The final question is whether it is worth the effort: why not just abandon the target and accept inflation of, say, 4 or 5 percent? The answer is that if a country abandons its solemn promise to stabilize the value of the currency as soon as it becomes too difficult to fulfill, then other commitments must also be devalued. At home and abroad, many will conclude that the UK is unable to keep its promises when times are tough. During the 1970s, that’s pretty much what happened: Britain started to become a joke. To repeat it, especially after Brexit, would be an unforgivable – possibly even incurable – folly.

martin.wolf@ft.com

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