Austerity is back, and this time it’s monetary

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The writer, an FT contributing editor, is chief executive of the Royal Society of Arts

The chorus of consensus on UK inflation and interest rates has risen several decibels recently. Economists, financial markets, commentators and politicians have been clear in their conviction that UK interest rates need to continue marching north to curb price pressures. With its 50 basis point rate rise last week, and accompanying messaging, the Bank of England is whipping this herd forward.

The latest set of UK inflation figures explain why, as headline inflation falls less than expected and core rates pick up to levels well above those of other countries and target levels. For many, this left the BoE with “no alternative” but to raise rates, with more to come until “every last drop” of inflation was squeezed out, as chancellor Jeremy Hunt put it. Not to do so, in their view, threatened the bank’s credibility.

There are good grounds for healthy scepticism about this herd mentality. Indeed, other policy choices are not just possible but desirable. Of course, many of these same people completely failed to foresee the rise in inflation in the first place. Those who, 18 months ago, saw all inflation misses as temporary hiccups now interpret them as persistent heart attacks. This risks overreaction and overcorrection, the zealousness of the late convert.

Higher and stickier inflation most likely reflects the UK’s more acute supply shortages than in other countries, notably in the labour market. These constraints are raising the level of prices, probably on a persistent basis. On this diagnosis, the textbook role of monetary policy is to tolerate, not offset, these temporary inflation misses provided inflation expectations remain anchored. Not to do so inflicts unnecessary further damage on growth.

This the UK economy can ill-afford. Growth is stalled and many households and businesses face double jeopardy. Knocked sideways by a large wave of cost of living rises, they are now about to be struck by a second wave of cost of borrowing rises. This will mean about 3.5mn mortgaged households see incomes fall by more than 8 per cent, to say nothing of the 4.6mn renters also affected if their landlords have mortgages.

Given a quarter of UK households have essentially no savings, this risks an outsized response to past monetary tightening in the form of lower spending and, ultimately, jobs. Past tightening of the monetary elastic is about to propel a brick towards the financially vulnerable. For the UK, that would spell recession.

But there is another way. Despite the headline inflation rise, inflation expectations remain anchored. Cost and price pressures are, or are about, to abate in the second half of the year. A year from now, a reasonable view would see inflation at 3-4 per cent without any further tightening. At those levels, it is highly questionable whether those last inflationary drops need to be squeezed out at greater speed. 

At 3-4 per cent, inflation no longer enters the public consciousness. That is why there is essentially no evidence it would impose costs that are any greater than at 2 per cent. But the costs of lowering inflation those extra few percentage points, measured in lost incomes and jobs, are larger at these levels of inflation. In the jargon, the Phillips curve flattens. Squeezing the last drops, at speed, would mean sacrificing many thousands of jobs for negligible benefit. 

It could be argued that tolerating above-target inflation for a little longer than usual is to ignore the inflation target mandate. It is no such thing. That framework and its open letter system gives the BoE and the chancellor all the latitude they need to extend the horizon over which inflation is returned to target. Indeed, this flex was built in precisely for these circumstances. The oddity is it is not being used.

Doing so would enable the bank to pause and take stock, smoothing the path of rates facing borrowers and thereby lowering the risk of policy-induced recession. Other options, such as leaning on lenders as both main UK political parties have proposed, are better than nothing but plainly far inferior to smoothing at source.

Imagine a doctor, uncertain about the nature and severity of a disease, who has administered a large medicinal dose which has yet to take effect. Prudence would cause them to pause to see how the patient responded before doubling the dosage. That principle is one central banks should heed now to avoid overdosing the economy. 

Over a decade ago, in pursuit of lower debt, the UK enacted fiscal austerity. This ruptured growth and was self-defeating for debt. Today, in pursuit of lower inflation, monetary austerity risks the same fate. It is time to steer the stampeding herd away from the cliff edge, for the sake of the financial security of millions of people and the credibility of our policy institutions.