The economy is in an extremely fragile place. GDP remains 3.3 per cent lower than it was before the pandemic began and the recovery appears to be stagnating.
This has resulted in consumer confidence falling to the lowest levels since February — when 1000s of people a day were dying of Covid-19. The economy is on a knife edge. So why are the Bank of England considering turning this stagnation into a recession through tightening the money supply?
Typically we think the role of the Bank of England is to ensure inflation is low and stable. What we often forget is that it’s also supposed to ensure “strong, sustainable and balanced growth”. That’s why it’s so baffling the new Chief Economist to the Bank of England Huw Pill has signalled that the Monetary Policy Committee may vote to tighten the money supply, either by selling long term bonds or increasing the bank rate.
The purpose behind both of these is to increase what economists call the real interest rate — that’s the actual cost a debtor pays for loans, and the actual yield their creditor receives. The logic behind tightening is that by making it harder for people to take out loans you can reduce inflation.
Talking in abstract about taking money out of the economy sounds fine, but the human costs can be astronomical. By slowing down the economy you don’t just reduce spending, you also make it harder to shop. Consumers have more trouble taking out loans to purchase things like houses and cars, and businesses find it more difficult to invest in new buildings, software and equipment, which in hand contributes to slower productivity growth.
It gets worse. Higher rates often result in what’s known as hot money flows — when foreign investors purchase Pound Sterling so they can save their money in British banks. Increased demand for Sterling naturally results in higher prices. This could impact tourism, making it more expensive for foreigners to spend money in the United Kingdom. But it’s not just tourism that’ll suffer, it’s all exporters.
Of course the costs of inflation can be harmful, but it is essential to remember that there are two types of inflation: transitory and permanent. Transitory inflation occurs when there’s a disequilibrium in the economy; it can normally be solved through market forces. Permanent inflation is much more problematic. It occurs when inflation is embedded in market equilibrium, or in economist terms, when nominal income is growing greater than capacity.
To be blunt, we’re currently experiencing the former. If Huw Pill is correct that we’ll reach 5 per cent inflation by the end of the year, it won’t be because we’re growing too quickly. It’ll come as a result of supply-side constraints. In August’s monetary policy report, the Bank explained that “world export prices, excluding fuels, are projected to rise by around 6 per cent in 2021” largely resulting from transport bottlenecks caused by supply chains failing to keep up with the world emerging from lockdown. Add to this soaring oil prices, and growing inflation isn’t really much of a surprise.
These crises are only temporary. As supply catches up to demand, increases in commodity prices will be followed by below-average inflation for those goods. Why trample our recovery to protect against inflation we know will be temporary?
Tightening rates now could be a self-inflicted economic disaster. Inflation imposes some costs on individuals and businesses alike, but there is very little risk of it doing long-term damage to the economy. A recession, on the other hand, would hurt us for decades. Such an event is looking increasingly likely, and monetary tightening could push us over the edge. The Bank of England must remember its duty to deliver strong growth or else we shall all suffer.