Est. 2024 · Bath, UK
Through the
Econ Lens
6 September 2024 · Ainesh Jamuar

Is the Bank of England responsible for the current inflation episode?

Inflation is a sustained increase in the general price level in an economy, which raises the cost of living for everyone within it. The rate of inflation measures the annual percentage change in the general price level. High inflation can have many causes. One is demand-pull inflation, which occurs when aggregate demand in an economy grows faster than aggregate supply. This creates excess demand and a market disequilibrium, and firms grasp the opportunity to increase their total revenue by raising prices, leading to inflation. This is common where aggregate demand has risen rapidly, for example in some developing countries where a large influx of people has entered the middle class. These households begin spending more of their increased disposable income, pushing up aggregate demand, and in the short term aggregate supply cannot respond quickly enough, creating inflationary pressures.

In this situation, monetary policy can be extremely effective. The central bank can raise interest rates, increasing the incentive for people to save and bringing aggregate demand down before it gets too high. Over the longer term, policies that encourage firms to borrow and invest in new technology can help aggregate supply catch up with aggregate demand.

Cost-push inflation occurs when the prices of raw materials around the world rise. This creates a domino effect of rising prices along the supply chain, increasing costs for producers, which are then passed on to consumers as higher prices. A prime example is the 1973 oil crisis, when Arab members of the Organisation of the Petroleum Exporting Countries (OPEC), which controlled a large share of the world’s oil production, imposed an embargo and cut output. This had a devastating effect on the heavily oil-dependent United States: a nation that had looked prosperous was humbled by severe fuel shortages and soaring petrol prices. Carmakers such as General Motors and Ford were forced to cut production and lay off workers, demonstrating perhaps one of the most staggering effects of a price rise in one raw material on the many goods that depend on it. Higher costs for firms reduce aggregate supply, shifting the short-run aggregate supply (SRAS) curve inwards, raising the price level and causing inflationary pressures.

Inflation can also be driven by a fall in the value of a currency relative to others. One cause of this is a rapid expansion of the money supply, which reduces the value of each unit of currency. A clear example is the sharp fall in the pound on the foreign exchange markets after the UK voted to leave the EU in June 2016. This depreciation was a worrying period for everyone in the British economy, as it made imports dearer, increasing the cost of imported materials for firms. This shifted the SRAS curve inwards, raising the price level and adding inflationary pressure. Since the UK formally left the EU in January 2020, new non-tariff barriers on trade with the EU, such as border checks and extra paperwork, have pushed costs up further, adding an estimated £250 to the typical household’s food bill between December 2019 and March 2023. Finally, reduced labour mobility has left some industries without enough workers. Sectors that previously relied on workers from countries such as Poland, who were often willing to work for lower pay, now have to offer higher pay packages to attract staff. This further increases firms’ costs of production, once again shifting the SRAS curve inwards and increasing inflationary pressures.

Is the Bank of England responsible?

So, is the Bank of England responsible for the current inflation episode? First, we need to look at the Bank’s role when it comes to inflation. The purpose of any central bank is to keep inflation relatively low and stable. In the UK, the Bank of England’s target is 2%, with leeway of ±1%. This allows for a sustained and controllable increase in the general price level without pushing millions of people into economic hardship. However, at the time of writing the rate of inflation is far higher than this, at 4.2%. This has had many adverse effects, magnifying the cost of living crisis and leaving many people unable to afford essential purchases or to heat and power their homes.

The UK’s inflation rate has been unusually high compared with similar economies, with Germany the closest among its peers, and there are several reasons for this. Firstly, the UK relies heavily on imports for food, and the COVID-19 pandemic, the Russia-Ukraine war and now the Israel-Gaza conflict have greatly increased the cost of importing food and other goods, pushing up the prices of most items in the UK economy. Furthermore, Brexit has introduced new trade frictions on food and other produce imported from Europe, further raising prices and putting more pressure on millions of households. Another reason is the UK’s heavy reliance on natural gas: although higher energy prices have hit every country, they have hit the UK harder than most. Additionally, the UK labour force is still suffering from the effects of the pandemic. Unlike many countries in the Eurozone, the UK still has around 400,000 more people out of the workforce than before the pandemic, a problem amplified by the labour shortages caused by Brexit. This has pushed up pay as firms try to attract workers, putting more pressure on firms’ costs and driving up prices across the economy.

When inflation rises like this, most central banks respond by raising interest rates to encourage saving and bring down aggregate demand and the general price level. Both the Federal Reserve and the Bank of England have done exactly this. However, the Federal Reserve is already considering bringing rates back down and has signalled that it will not need to raise rates further in 2024, whereas the Bank of England says rates will have to stay higher for longer and that it is too early to talk about cuts. Some economists argue that although the Bank of England began raising rates first, the Federal Reserve made larger and faster increases, and there is evidence that this strategy of taking the hit early has helped the US bring inflation down more quickly than the UK.

The UK government is also responsible for inflation in other ways, particularly through its response to the pandemic, when it borrowed heavily to fund schemes such as furlough, while the Bank of England’s quantitative easing effectively created new money to support that borrowing. Furthermore, cheap loans and easy business debt finance kept consumption high and allowed firms to keep prices down, but this also created many ‘zombie firms’ that could not survive on their own and became almost entirely reliant on cheap debt. Together with an insufficient fall in aggregate demand, this is perhaps one of the most important reasons for the high interest rates in the UK today, as the Bank now tries to reduce aggregate demand to bring inflation down.

However, the situation ultimately became this dire because of the Bank of England’s flawed initial plan to save the economy in the short term and worry about the longer term later. This did save the economy in the short term, but it set the UK up for the staggeringly high rates of inflation and interest that we see today. The Bank also incorrectly labelled the high inflation of 2021 as “transitory”, which led many firms and individuals to make the wrong financial decisions. They borrowed money to get through that period, expecting rates to return to normal so that they could pay off their loans afterwards. When it became clear that high inflation was here to stay, it was too late, forcing many companies into bankruptcy and others to let go of many workers.

There are many possible reasons for these errors, for example the lack of intellectual diversity at the Bank of England. Its leading panels are often made up of people who think alike and rarely include members with conflicting points of view, which means its forecasts and policy plans are not challenged enough. At the same time, the Bank’s remit has grown significantly in recent years, and this growth has not been matched by an increase in accountability and scrutiny from Parliament, which I believe is wrong. An independent central bank has to reassure markets and make critically important decisions with absolute precision, yet the Bank of England has been able to operate largely as it wishes, blurring the lines between monetary and fiscal policy through quantitative easing. QE provided cheap finance for government borrowing, allowing the government to borrow huge amounts at relatively low cost. Since 2008, however, government debt has risen from around 35% to around 75% of GDP, and as interest rates have risen, so has the cost of servicing that debt. Therefore, it is essential that we make the Bank of England more accountable for its actions and put enough pressure on it that it changes its ways and considers a wider range of ideas in its forecasts and plans.

How the Bank uses DSGE models

One way in which the Bank of England aims to control inflation is by using Dynamic Stochastic General Equilibrium (DSGE) models as a key tool in its monetary policy framework. The first use is modelling the economy: DSGE models simulate the economy by incorporating economic agents such as households, firms and the government, and their interactions. These models include equations that describe how these agents respond to changes in economic conditions, such as shifts in inflation, interest rates and output. Another use is analysing economic shocks: the models help policymakers understand the impact of different shocks (e.g. changes in oil prices or technological advances) on the economy. By simulating these shocks, the Bank can predict how inflation and other macroeconomic variables might respond.

The Bank also uses them for policy simulation. DSGE models allow it to test the effects of different monetary policies before implementing them, for example simulating the impact of raising or lowering interest rates on inflation and economic growth. This helps in designing policies that can effectively stabilise inflation. Additionally, the models are used for forecasting: by inputting current economic data, the Bank can generate forecasts for inflation and other key variables, which helps it set appropriate monetary policy to achieve the inflation target. Finally, DSGE models are used for policy communication. The insights they provide are used to explain the rationale behind policy decisions to the public and financial markets, and this transparency helps manage expectations and strengthens the credibility of the Bank’s commitment to controlling inflation.

Making the Bank more accountable

There are several things we could do to make the Bank of England more accountable. For example, it could be required to respond formally to external challenge from groups such as the Institute of Economic Affairs’ Shadow Monetary Policy Committee, justifying its agenda and showing that what it is doing is in the best interest of the people of the United Kingdom. This would also increase the level of intellectual diversity and put a wider range of options on the table when the Bank decides how to respond to issues such as inflation.

The US has a system similar to this proposal. When the Federal Reserve was created, the US rejected the idea of concentrating all responsibility and power in one central bank and instead split it up into a central governing board, a decentralised operating structure of 12 regional Reserve Banks, and a combination of public and private characteristics. The system has three key entities: the Board of Governors, the Federal Reserve Banks and the Federal Open Market Committee (FOMC), and Congress oversees the whole system. In this structure, the Reserve Banks are supervised by the Board of Governors, and monetary policy is set by the FOMC, which includes both Board members and Reserve Bank presidents. This makes the US central bank more accountable for its actions and puts more pressure on it than on the Bank of England, forcing it to consider a range of ideas and scrutinise each one to choose the best. The Fed also draws on several advisory councils, which help ensure it has the resources to make the most informed decision for the whole country. This is perhaps why it took a more aggressive approach to tackling inflation, compared with the Bank of England, which was able to play it safe without fearing the consequences.

A similar system can be seen in the European Union, where the European Central Bank (ECB) sets interest rates, manages the euro area’s foreign reserves, authorises the issue of banknotes and much more within the Eurozone. The ECB has three decision-making bodies: the Governing Council, which is the main decision-making body; the Executive Board, which handles the day-to-day running of the ECB; and the General Council, which plays a more advisory and coordinating role. This is yet another system the UK could learn from, to make sure we hold the Bank accountable for its choices and ensure it has enough intellectual diversity when making its most important decisions, in the hope of avoiding another period of inflation as high as today’s.

References

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