The Bank of England - the old lady who swallowed a fly.
There are some who suggest that central bankers tolerate inflation in anything but wages. Andrew Bailey, the governor of the Bank of England (BoE), has at least been consistent with this approach during the recent rise in UK inflation rates. Back in February last year, Mr Bailey said workers would have to accept the pain of prices rising faster than wages1. Suck it up, basically.
Last month, the BoE’s chief economist Huw Pill doubled down on this miserable message, saying Brits would need to “accept they’re worse off and stop trying to maintain their real spending power”2. With ongoing strikes by healthcare workers, rail employees, the postal service, the education sector and others, it doesn’t feel as though Britain’s workers are in tune with monetary authorities.
The BoE base rate was raised to 4.5% this month, and analysts expect it to rise further over the summer to a terminal level of 5.25% or perhaps a little higher. These rate hikes have seemingly done little to temper inflation. April saw food inflation at 19.1%, while core inflation (excluding food and energy) worryingly rose to 5.8%3. With private sector wages up 7% in March, Mr Bailey is now suggesting that those pesky workers are keeping inflation high through their wage demands4.
When not calling-out workers and their rational expectations on wage increases to counter inflationary pressures, Mr Bailey has also taken aim at the UK’s investment industry for focusing too much on low-yielding assets like bonds and ignoring “risk taking and productive finance”5. The liability-driven investing (LDI) crisis which hit the UK pension industry last autumn certainly shows that funds were overly-focused on low-yielding investments, but the near collapse of the UK gilt market in October suggests there was also an awful lot of risk taking in the form of highly-leveraged interest-rate swaps.
Setting aside the probable cause of this over-use of leverage in the pension industry (regulatory changes implemented in 2000 which put pension deficits on company balance sheet and the trend to using interest-rate derivatives to manage the balance-sheet volatility resulting from this), the crisis itself was the result of the BoE’s rapid rate hikes last year. This caused huge mark-to-market losses for the pension industry of a severity which forced the BoE to intervene in the bond market even while it was trying to reduce the size its own balance sheet, a U-turn the BoE doesn’t really want to talk about too much.
The graph below illustrates the role BoE policy has played in the UK’s unhappy decade and a half of low growth and poor investment appetite. Base rates hit 0.5% in March 2009 and barely moved up or down until the hiking frenzy which began in December 2021. To blame the UK investment industry for its lack of risk taking when yields were so low for so long seems a bit rich of Mr Bailey.
Aside from supply-chain disruptions during the pandemic, the effect on energy prices from the sanctioning of Russian oil and gas exports and doubtless Brexit (it always gets a mention), the real cause of the recent spike in inflation was the huge increase in the money supply during the Covid-19 lockdowns as the BoE effectively monetised the UK government’s deficits during that period (see graph below). This was BoE policy, and while Mr Bailey is loath to talk about it, clearly the central bank must take some responsibility for the consequences.
It’s rare for public officials to issue a mea culpa for poor policy outcomes. Oddly for central bankers, it often seems to be the event of leaving office that encourages them to become more forthright about the limitations of monetary policy and the problems of policy mis-steps. Former BoE governor Mervyn King is a perfect example of this, expounding as he did a high-level analysis of the issues facing the monetary system in his 2017 book ‘The End of Alchemy’ (Mr King left office in 2013).
Perhaps the most profound analysis of policy mistakes in recent times has come from the pen of Robert S. McNamara, Secretary of State for Defence during the Kennedy and Johnson presidencies when US involvement in Vietnam escalated with dire consequences for all involved. Described by the Wall Street Journal as ‘unsparing’, Mr McNamara’s ‘In Retrospect’ received vociferous condemnation from some quarters, especially the New York Times, the original, brave publishers of the ‘Pentagon Papers’ in 1971.
The Times did however overlook the key fact that the Pentagon Papers were themselves a project instigated by Mr McNamara in 1967 as a means of cataloguing the slide into war in part as a guide to future policy makers to highlight the mistakes the US had made and was continuing to make once it became involved in a seemingly-intractable and unwinnable war.
‘In Retrospect’ highlights, in excoriating detail, the strategic and tactical mistakes made by successive administrations with respect to US policy in South-East Asia, from assuming a world view (containment of communism and the fear of a domino effect which meant the religious, nationalistic and political issues in Vietnam were misunderstood), to mission creep (forgetting that US involvement was based on South Vietnam leading the fight, and that this relied on political stability in Saigon) and a hubristic assumption in America always being able to win through technology and military might despite the problems of fighting a counter-insurgency action.
Saddest of all are the fears of loss of reputation and influence that kept the US escalating a conflict when it was becoming clear to insiders that the situation was untenable and that early withdrawal might in fact be the best option. The narrative around peace talks in 1967 being disrupted due to heavy bombing around Hanoi and Haiphong as the air force ‘caught up’ on air raids which had been delayed by bad weather are particularly illustrative of the problem of events progressing such that the left hand doesn’t know what the right hand is doing.
One lesson Mr McNamara sought to highlight was the failure of the executive to consider properly the real implications of early withdrawal, de-escalation and peace talks because of a fear of a loss of reputation. 1965 was the point at which the US effectively crossed the river Styx, committing ground troops for the first time and actively taking the fight to the NVA and Viet Cong. Perhaps when the economic history of the 2020s is written, some point in 2020 or 2021 will mark a similar moment when debt, money printing and then inflation seemingly started to take on a life of their own.
Worryingly for the BoE, UK bond yields are on the rise again, with the 10yr reaching levels seen last autumn (see graph above). This time, emergency budgets and ‘Trussonomics’ cannot be blamed. With a flood of bond issuance likely to follow the passing of the debt ceiling in the US, upward pressure on yields globally may also be reflected in the UK. The pound is holding up for now, although the medium-term prognosis is poor, especially given the current-account deficit, high levels of taxation, poor growth expectations and the apparent failure to harness any tangible benefits from Brexit.
Judging by the current tone of rhetoric from the BoE, we should expect more finger pointing as well as more ‘emergency measures’ to deal with the consequences of the combination of poor fiscal and monetary policy. A candid assessment of the BoE’s role in the current cost of living crisis, not just in terms of the initial money printing but the BoE’s slow reaction to the inevitable inflationary consequences of it, are sadly not something one should wait up for. Talking about learning lessons as Mr Bailey did last week doesn’t really cut it.
Perhaps last autumn’s emergency bond-market intervention was the bit in the song where the old lady of Threadneedle Street swallowed a cat to catch the bird, or a dog to catch the cat. Given the current state of affairs, it feels as though she may well end up having to swallow a lot more in the coming years. Perhaps a donkey.
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Szu Ping Chan, Don’t ask for a big pay rise warns Bank of England boss, BBC, 04/02/2022.
Jenni Reid, Brits need to accept they are now poorer, Bank of England chief economist says, CNBC, 26/04/2023.
Valentina Romei, Shop price inflation hits record highs, say retailers, Financial Times, 30/05/2023.
Eir Nolsoe, Andrew Bailey admits Britain is suffering a wage-price spiral, Daily Telegraph, 17/05/2023.
Simon Foy / Melissa Lawford, Lack of risk taking in the City threatening the economy, warns Bailey, Daily Telegraph, 24/05/2023.