Until recently, the Bank of England’s Monetary Policy Committee (MPC), which has responsibility for setting interest rates, was undecided if conditions were right for tightening monetary policy. Andrew Bailey, the Governor of the Bank of England (BoE), revealed in August that the MPC could not categorically say that there was clear evidence that significant progress was being made in eliminating spare capacity and achieving the two per cent inflation target sustainably.
But given recent data on both inflation and labour it might now be an appropriate time for the BoE to take its first steps in tightening monetary policy. The annual inflation rate jumped more in August than at any time since the BoE was granted independence. Analysts expect the rate to rise from the 3.2 per cent in August to peak at over 4 per cent in the winter and remain more than one percentage point above the BoE’s two per cent target until at least autumn 2022. Job vacancies are also at their highest level ever recorded, indicating strong demand for labour. Payrolls are now at pre-pandemic levels indicating that significant progress has been made in eliminating spare capacity. We have also seen the number of adults who are not working but say they want a job fall to its lowest level since such records began almost 30 years ago. The BoE is also far more likely to damage its credibility by overshooting rather than undershooting its inflation target.
The questions for the MPC will be what to do and how quickly. It will not want to tighten policy too early, as this could undermine the recovery from the pandemic and damage living standards. But if it tightens too late, the inflation genie could well and truly escape from its bottle, forcing the BoE to be much more aggressive with subsequent interest rate rises.
Until recently, most economists agreed the first risk was more serious. It made sense for the BoE to do nothing, with Governor Bailey downplaying the risk of overshooting inflation with public comments stating the BoE was monitoring inflation very carefully. Fortunately, the BoE has one tool at hand with which it can tweak its stance on monetary policy and, indeed, at its most recent meeting the MPC stated there would be ‘some modest tightening of monetary policy’ in order to meet the inflation target. It could therefore cap its QE at around £870bn rather than continuing to the end-of-year target of £895bn. Such a move should offer little risk of undermining the recovery and it would show markets and investors that the BoE was being vigilant about rising inflation.
Recent data suggests that the UK’s economic backdrop has changed and that the MPC now needs to show that the BoE is serious about inflation. Capping QE may mean it can put off putting up interest rates for a while and still give retain the option of loosening monetary policy once again if the recovery proves disappointing. The timing of any interest rate rise is uncertain. However, it feels like that time is getting closer as we enter the Autumn.