Why does the Bank of England appear to be ignoring its mandate?

 

The MPC has raised rates by 0.5%, and forecast both very high inflation and a recession. To many people this will come as no surprise. When inflation is high and expected to go higher, central banks raise interest rates to reduce inflation. It’s what they do. A recession is just an unfortunate consequence of that.

However the Bank of England has a mandate set by the Chancellor. Significantly, that mandate is set out in the eighth paragraph of their summary about today’s decision. It is worth quoting what it says in full:

“The MPC’s remit is clear that the inflation target applies at all times, reflecting the primacy of price stability in the UK monetary policy framework. The framework recognises that there will be occasions when inflation will depart from the target as a result of shocks and disturbances. The economy has continued to be subject to a succession of very large shocks, which will inevitably lead to volatility in output. Monetary policy will ensure that, as the adjustment to these shocks occurs, CPI inflation will return to the 2% target sustainably in the medium term.”

It is an odd paragraph, because its first sentence is (rightly) contradicted by what follows. Every economist knows it would be impossible to hit 2% inflation every quarter or year, and foolish to try, especially when energy prices are rising so fast and unpredictably. For that reason, the key mandate is given by the last sentence, and you could add that the Bank should try and make this return to medium term stability as painless (in terms of excess inflation and lost output) as possible.

The table below gives the path of inflation in the two forecasts published today that the Bank traditionally presents: one based on market predictions of future Bank decisions (yet more increases), and the other assuming interest rates remain unchanged at their new level.

	22Q3	Q4	23Q1	Q2	Q3	Q4	24Q1	Q2	Q3	Q4	25Q1	Q2	Q3
Market rates	9.9	13.1	12.8	11.9	10.5	6.4	5.0	2.5	1.9	1.4	1.1	0.9	0.8
Flat rates	9.9	13.2	13.0	12.2	10.9	6.8	5.5	3.0	2.5	1.9	1.7	1.5	1.3

Now if the Bank were setting rates so “inflation will return to the 2% target sustainably in the medium term” (see above) then that clearly does not happen in either of these forecasts. In 2025 inflation is well below 2% and falling. I’m used to seeing Bank forecasts after they increase rates where at least one of these forecasts shows inflation nicely settling to close to 2% by the end of the forecast period. Not this time.

While most people will understandably focus on the very high figures over the next year, a comparison of the two rows will tell you something Bank economists always stress, which is that it takes time for changes in interest rates to influence inflation. So raising rates now will have little impact on inflation over the next year, which as the Bank shows is substantially a direct consequence of higher energy prices. What raising rates by 0.5% today does is to prolong the recession the Bank is forecasting, and this is why we see a collapse in inflation in 2024 and 2025 in these forecasts. Unemployment is expected by the Bank to be around 6% in three years time, and rising.

So it looks as if the Bank, by raising rates by 0.5%, is helping the economy stagnate into a prolonged recession with collapsing inflation well below the target and with rising unemployment. In fact it’s worse. Both forecasts above assume that energy prices stay high. The general expectation, and the assumption in futures markets, is that energy prices will fall back considerably over this period. The Bank provides an alternative forecast based on market expectations of interest rates where energy prices follow expectations in future markets. The level of inflation expected in 3 years time is then not 0.8% as above, but 0.3%!

So has the Bank departed from their mandate? That is a very serious charge, so I have been trying to work out what the MPC might say if I put that question to them. The first and obvious point is that MPC members are not bound by the Bank’s forecast. However if MPC members think that the Bank is too pessimistic on the length of the recession and medium term inflation they should really speak out, given how awful the Bank’s forecast is. A second obvious point is that the Bank could cut interest rates over the next year or so, which could avoid the collapse of inflation below target expected in 2025. But do they really believe that kind of very fine tuning works, and shouldn't they be open about what they expect to do? 

I want to go back to that rather odd paragraph that I quoted at the beginning. Why was that first sentence included, given that it was then immediately contradicted? The political explanation for why the MPC might raise rates today, even though they expect that decision to have very negative consequences later, is that with inflation expected to hit double figures they felt they had to raise rates. Hence the first sentence in that paragraph. But I really hope that is not the reason, because one of the justifications of having an independent central bank is that it is not subject to these kinds of short term pressures, although on this occasion our expected next Prime Minister has not been helpful in that regard.

When policymakers make an expected recession deeper and more prolonged through their actions, they need to provide very good justifications for doing so. Current high inflation is not a justification, as there is little the Bank can do about that. Their own forecast suggests that they are either raising rates excessively today, or they expect to reverse course fairly soon. Someone should really ask which of these is the case, or whether there is something else that I have missed.

Postscript 05/08/22

I missed one additional explanation for this inflation overshoot, which is that the Bank assumes current fiscal policy. Perhaps the MPC are assuming that the government will introduce a large additional degree of fiscal support for those on lower incomes, which isn't in their forecast, and this will stop the excessive inflation and output collapse they are showing. But the tax cuts promised by Truss, which go to the better off or corporations, provide much less stimulus. Excessive monetary tightening based on a guess of fiscal loosening is a dangerous game to play.