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At this point in the inflation process, the central bank needs to show moral fiber. A 0.5 percentage point hike in the BoE’s intervention rate last week was undoubtedly necessary. The output rate may be 5 percent will not be peak. However, doing whatever it takes to bring inflation down to the target is more than desirable, it is a legal duty of the bank. No one on the Monetary Policy Committee is free to ignore this commitment.
Nor is it now impossible to insist on imagining that what is happening in the UK is nothing more than a temporary bout of imported inflation. The latter was always likely to trigger an inflationary process. So, actually, I did. Annual core inflation (which excludes food and energy prices) was 7.1 per cent in the UK in the year to May, services inflation was 7.4 per cent, and the three-month moving average annual growth of private sector wages (excluding bonuses) in April was up to 7.5 per cent.
Such a rate of wage increases is not surprising. In April, real average weekly earnings were 4 percent below their level two years ago and at the same level as in August 2007. The unemployment rate in the first quarter of 2023 was also just 3.9 percent. This indicates a very tight job market. Why, under these circumstances, would anyone expect workers to accept deep cuts in real income? At the same time, the current rates of wage inflation clearly do not correspond to 2 percent inflation.
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Something must change drastically and soon. We are witnessing a price-price-wage spiral radiating throughout the economy. The only way to stop this is to remove the compliant application. In other words, the question is not whether or not there will be a recession. It is rather whether there is needs To be one, if the spiral were to stop. The reasonable opinion is that the answer to the last part of this question is “yes”. Like it or not (I certainly don’t), the economy will not return to 2 percent inflation without a sharp slowdown and high unemployment.
This raises four questions.
The first is whether current monetary policy is tight enough. The argument that might be made is that borrowers are highly exposed to higher nominal interest rates, long after very low rates. As against this, the nominal rate of 5 percent means today a real rate of less than minus 2 percent. Moreover, the pressure will come very slowly. According to the Financial Conduct AuthorityIn the second half of 2021, 74 percent of mortgages had fixed-rate rates between two and five years. In short, prices may have to rise again.
The second is whether the government should soften the blow to borrowers. The answer is absolutely not. One reason is that people with large mortgages are relatively well off, eg Torsten Bell of the Resolution Foundation points out. The right policy is rather targeted assistance to the most vulnerable. Another reason is that this would defeat the purpose of the exercise, which is to tighten the dial. If fiscal policy is going to offset this, monetary policy will have to remain much tighter than otherwise. If the desire is to ease monetary pressure, fiscal policy should be tightened, not loosened.
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And the third is whether the uncertainty surrounding all of these decisions should in itself encourage extreme caution in tightening. Unfortunately, it’s not that simple. It is true that there is a lot of uncertainty about the strength of the underlying inflationary pressure as well as about the depth of the economic slowdown needed to bring it under control. Likewise, there is a great deal of uncertainty about how much tightening would be required to cause such a slowdown. But if one is determined to bring inflation back to the target in the near future (i.e., in less than two years), it is not true that the smallest error would be to err on the side of optimism about how easily inflation will come down. Less work would reduce slowdown now. But if it fails to achieve the required drop in inflation, a larger deceleration may be required later on, when inflation is more well-established.
The final question is whether it is worth the effort: Why not abandon the target and accept, say, 4 or 5 percent inflation? The answer is that if a country abandons its solemn promise to fix the value of a currency once it becomes difficult to fulfil, then other commitments must also be devalued. At home and abroad, many will conclude that the UK is unable to deliver on its promises when the going gets tough. That’s what happened, in large part, during the 1970s: the United Kingdom started to be a joke. To repeat this, especially after Brexit, would be unforgivable folly – and perhaps even irremediable.
martin.wolf@ft.com
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