What is the Bank of England playing at?

6 November 2021

10:58 PM

6 November 2021

10:58 PM

Last week, the Bank of England sent a number of confused messages. One was almost shocking: Andrew Bailey said that it isn’t his job to steer markets on interest rates ‘day by day and week by week’. But as economic commentator Matthew C. Klein dryly noted this is literally his job. It is debatable whether the Bank of England needs to manage the entire yield curve (ie, buying and selling bonds in an attempt to set interest rates years into the future) but the central bank should be in charge of the short end.

Those opposing an interest rate rise say that central banks should never shock markets. The Bank of England should copy the ECB, it’s argued, and start giving guidance on interest rate rises months in advance. But this goes against the independence of monetary policy boards, who are legally mandated to set policy in line with their targets. Not only do they have the right to change their mind and hike rates if circumstances change, they are legally obliged to do so.

Andrew Bailey tried to steer expectations when he said the Bank was still concerned about inflation, adding that rates would have to go up over coming months. That must rank as one of the more confusing statements I recall hearing from a central banker. He is really saying that the risks are finely balanced — and that he prefers sitting on the fence until he thinks he has more clarity.

The outlook for UK economic growth has indeed weakened — due to rising energy costs and persistent supply-chain bottlenecks. This scenario (if it were to continue) could turn into stagflation. The central banking world is unprepared for this because most bank forecasting models have never been tested in a period of rising inflation. That test is now very likely to occur.

The current generation of central bankers have no professional memory of central banking in a high inflation environment. But they do remember policy mistakes the ECB made in 2008 and 2011 — when it raised rates, but shouldn’t have. That is the mistake the ECB and the Bank of England now seem to intend to avoid at all costs.

This is what some central bankers mean when they say they would rather overshoot the inflation target than undershoot it. This is the error they know, an error that many of them made themselves back in the day. But there are no institutional memories of errors committed in high-inflation periods.

It is interesting to see central banks in eastern Europe pursuing a very different strategy. Their situation is different too, but the big difference is that they are following their policy mandate literally, rather than trying to engineer a soft landing. The central banks of the Czech Republic and of Hungary started to raise interest rates this summer. The Czech central bank raised rates by a whopping 1.25 per cent to 2.75 per cent this week. Russia’s hawkish central bank governor has raised rates to 7.5 per cent in view of an inflation rate that currently runs at 8 per cent.

These central banks are acting in the way western central banks used to act in the 1980s and 1990s, moving quickly when the ECB and the Bank of England do nothing. It will be interesting to watch how this east-west divide will unfold.

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