Four to 5pc inflation by the end of the year? That’s not something we have in our forecasts, Andrew Bailey, Governor of the Bank of England, said in a recent radio interview to mark his first, turbulent year in the job. In point of fact, it is, though admittedly it forms no part of the Bank’s central projection.
But it is very much in the Bank’s range of possibilities, and one moreover which in view of today’s extreme levels of uncertainty is judged rather more likely than normal. In its latest February forecasts, the Bank’s Monetary Policy Committee judged there to be a one in three chance of inflation being both below zero, and above 4pc by the end of this year.
We already know what the Bank plans to do if the former of these possibilities is the way it goes: impose a negative interest rate. Banks have been asked to prepare for just such an eventuality. Far less certain, however, is how it responds if inflation follows the latter trajectory. Does it come down hard on the rise in prices by increasing interest rates, or does it choose to treat the phenomenon as a temporary spike that can be safely ignored?
More to the point, can deeply indebted Britain actually afford a meaningful rise in interest rates? This is not just a question for the UK: the same can be asked of the world economy as a whole.
For illustrative purposes, let’s assume that the UK’s entire, £5.5 trillion (roughly 270pc of GDP) stock of public and private non-financial sector debt is linked to Bank Rate. A one percentage point rise in short-term rates would add £55bn to annual debt servicing costs. At 2.75pc of GDP, this would be a massive potential hit to demand. In the real world, of course, much of this debt is fixed rate, not variable. That lessens the impact somewhat. But only somewhat.
As the Office for Budget Responsibility has observed, the effect of extensive quantitative easing is to shift a great slab of the national debt from long-term fixed to short-term variable rates. For now, with Bank Rate at just 0.1pc, that’s extremely helpful to the Government, in that it can borrow with impunity at virtually no cost.
But it severely restricts the Bank of England’s ability to raise rates in future without severely damaging the public finances, never mind the impact on overgeared households and businesses.
None of this matters, of course, if there is no inflationary threat. Many of those warning of it tend to be the same people who were also sounding the alarm after the financial crisis more than a decade ago; their concerns were proved comprehensively wrong. Are they not crying wolf again? The US saltwater economist Paul Krugman has been unrelenting in his derision. The lesson of the 2010/11 crisis, he notes, is “don’t panic”; there will be no return to 1970s style stagflation.
Well, maybe, but as Andy Haldane, chief economist at the Bank of England, observed in a recent speech, the chances of it are a good deal higher this time around than last. Haldane is something of an outlier among policymakers on these matters, but there are lots of reasons for thinking he’s right. Let’s briefly count the ways.
For a start, there has been considerably more fiscal and monetary support this time around than last. Furthermore, it takes place against the backdrop of a very odd looking downturn which has nothing to do with the normal ups and downs of the business and credit cycles. Rather, it is an induced recession that will correct itself of its own accord the moment the pandemic is over. Any long-term scarring is therefore likely to prove relatively limited, with UK unemployment expected to peak at little more than 6pc, extraordinarily low by the standards of most recessions.
What is more, people have not been able to spend in the way they would normally, resulting in a large buildup of household and corporate savings.
At least some of this will get spent as the restrictions lift. Publicans and other businesses badly affected by lockdown are almost bound to raise their prices quite considerably in an effort to recoup losses. Starved for more than a year of the ability to spend, consumers won’t much care what it costs. They’ll pay almost anything for a pint in the pub. In time, these rising prices will pull earnings up behind them, threatening a classic inflationary spiral of rising price expectations and wages to match.
1/3 chance of negative rates.... 1/3 chance of 4%+ rates....
Basically they don't have a clue what is going on or what the likely trajectory is... Oh well I'm glad I'm not the only one.