In February 2021 the Bank of England’s Monetary Policy Report predicted an inflation peak of 2.1%. In May 2021 the forecast peak was raised to 2.3%.
In August 2021, acknowledging that inflation was already 2.5% and above the previously forecast peak, the new forecast peak was raised to 4.0%. In November 2021, noting that inflation in August had already reached 3.2%, the Bank raised its forecast of peak inflation to 4.3%.
By February 2022, noting that inflation had already reached 5.4% in December, the Bank adjusted its forecast for peak inflation to 7.25%. Finally, the most recent report, released in May, noting that inflation had already risen in March 1 percentage point higher than had been predicted in February, revised the forecast of peak inflation to over 10% in Q4, five times higher than the 2% target.
There needs to be an investigation of why the Bank’s forecasting performance has been persistently behind the curve. Such an investigation needs to take evidence from the range of forecasters in the private sector whom the Bank does not normally consult directly, many of whom have had a much better track record recently. The Economist magazine rather cheekily suggested that central banks had diverted their focus to other “more exciting” topics like climate change and diversity and had got bored with simply attempting to target price stability. Such a shift of focus may have affected some central bankers but there is no evidence from Monetary Policy Committee (MPC) minutes of any discussion of diversity and climate change. The problem looks to be more simple – systematic forecasting failures.
But even if the Bank had succeeded in forecasting a bit better, could it have done much to prevent inflation rising when faced with massive external shocks from rises in world energy and food prices?
The Bank has now increased its base rate to 1% which is not nearly high enough according to orthodox macroeconomic theory. Theory suggests that for monetary policy to be tight in absolute terms, the real interest rate must be positive. To achieve this would imply raising nominal interest rates to intolerable levels. This suggests that unless there are external forces bringing inflation back towards target, there is not much the Bank can do without severely damaging economic growth.
Moreover, positive real interest rates would additionally cause a large increase in government’s debt-to-GDP ratio. The lower inflation caused by making real interest rates positive would increase the real value of government debt: transferring wealth from debtors such as the government to its creditors – government bond holders. Higher interest rates also push up the debt-to-GDP ratio. For instance, if base rates were to rise to an average of 8% over the next 12-18 months, causing GDP to fall by an assumed amount of only 3% while inflation falls on average by 6% the UK’s debt-to-GDP ratio could rise from its existing level of 96.2%1 to around 113%.
Optimal policy is not always to hold inflation down. In the interwar years, the economic background was deflationary, not inflationary, and the countries who returned to the Gold Standard in the 1930s at the pre-First World War parity generally faced much worse negative output shocks than those who allowed their currencies to weaken.
The experience of the 1970s shows some of the consequences for countries attempting to insulate themselves from an international inflationary surge, Then, both Switzerland and Germany followed much tighter monetary policies than the rest of the world. Swiss inflation still peaked at 9.8% in 1974 but then fell back to 1.0% by 1978. German inflation reached 7.0% in 1973 before falling to 2.7% by 1978. Both these rates were much lower than the inflation rates experienced in other countries.
But to achieve this, Switzerland had to face declines of GDP of 7.5% in both 1975 and again in 1976. The hit to German GDP was less, with zero total growth from 1973-75. But even this was a sharp change from the previously buoyant trend.
In both countries the hit to growth was only socially feasible because of the practices of “gastarbeiter” (literally guest workers) from other countries who when they lost their jobs had to return home to Turkey, former Yugoslavia and Southern Italy. Sending migrant workers home is no longer a feasible policy.
Sign up for our FREE Reaction Weekend Email
Read the week's best-read articles on politics, business and geopolitics
Receive offers and exclusive invites
Plus uplifting cultural commentary
So in practice, even had the Bank been good at forecasting, we suspect that it would have been hard for it to prevent an inflationary surge because of the cost to output and employment.
However, it might have managed two things. The first is that earlier monetary tightening would probably have reduced the inflation peak. And second, the recent weakening of the pound against the dollar which is the important currency for pricing commodities – a 10% fall since end February – which will certainly add to inflation might have been prevented.
But in the short-term inflation has won the battle. Whether it remains above the 2% target in the medium term will depend more on whether international prices fall back than on domestic monetary policy. Long-term, this victory has implications for the credibility of the monetary policy framework.