UK inflation will fall, but neither the BoE or the government deserve applause

A significant fall in UK inflation is in prospect, writes Tim Congdon

 
In the two months to May 2023 the consumer price index rose by 1.9%. It is very improbable that the CPI will increase by as much as that in the two months to May 2024, even though – for example – oil prices have advanced quite briskly in recent weeks. Suppose that the CPI goes up by 1.0% in the two months to May 2024, which is very much on the pessimistic side of expectations. Then the annual rate of change will drop between March and May by (([1.019/1.01] – 1) x 100)%, which is roughly 0.9%. The annual rate of change in the CPI was 3.2% in March. With the assumed 1.0% increase in the two months, the annual rate of change in May – to be announced in June – will come to 2.3%. This will be close to the official 2% target and well within the permitted band of 2% plus or minus 1% either side of the 2% figure. Indeed, lower numbers are plausible.
 

 
Will the Bank of England then deserve applause for bringing inflation back on track? In the accompanying video I argue that it most certainly does not deserve any applause. In 2020 and 2021 the Bank organized very large purchases of assets, mostly gilt-edged securities, and so increased the quantity of money sharply. As the chart below shows, in the two years to end-2021 UK banks’ “lent” almost £400b. to the public sector, equivalent to about 18% of M4x broad money at the end of 2019. (The “loans” mostly took the form of increases in banks’ cash reserves, which created funds used by the Bank to purchase the gilts, mostly from non-banks.) Here was the dominant contributory factor in the surge in M4x growth in that period, with its annual rate of increase peaking at 15.4% in February 2021. The excess money growth then caused the asset price mini-bubbles which were a feature of 2021, and acceleration in the rises in the prices of goods and services which resulted in double-digit consumer inflation in late 2022 and early 2023.

However, a fashionable narrative has emerged in which the inflation flare-up of the early 2020s is attributed to external shocks such as the jump in food and energy prices arising from Russia’s invasion of Ukraine. Parts of the media have been bamboozled by this narrative, which is widely shared in central bank circles and not just in the UK. The media and central bankers may proceed from there to praise the Bank for bringing inflation under control, despite (as they see it) the hostile international environment.

The British government is likely to embrace this kind of soft-soap and may try to participate in the acclaim. The essence of the post-1997 arrangements for the Bank of England’s operational independence is that decisions affecting the rate of inflation (or deflation) are taken out of party politics. All the same, in January 2023 the Prime Minister Rishi Sunak made a commitment to halve inflation, which at that time was still in double digits. As a halving of inflation had indeed happened by the end of 2023, Sunak may be ecstatic about the further halving of the inflation number and the return to target. He needs to be told that – constitutionally – he is meant to be silent about monetary policy.

Moreover, the latest increase in the UK’s minimum wage – of no less than 9.8%, to take effect this month – has been blessed by Sunak and his ministers, even though it is plainly inconsistent with 2% inflation. Could someone tell Sunak that, in many small businesses, a 9.8% increase in the hourly rate for the lowest-paid has knock-on effects for those well above the lowest-paid, because of differentials in skill and experience? And does anyone in his wretched government understand that the relentless increases in the inactivity rate and the benefits bill reflect these misguided interventions in the labour market?

To my surprise, Ben Bernanke – the former chair of the Federal Reserve and the 2022 Nobel economics laureate – was critical of the Bank of England in his recent review of its forecasting performance. (In an article in The Critic I wrongly proposed that he would whitewash the institution.) Nevertheless, his critique of the Bank is very different from mine. He seems to believe that the setbacks of the early 2020s stemmed partly from a misdirection of the Bank’s resources, with the implied answer being that the Bank should commit more money and people to the forecasting effort. In my view, that is nonsense. Far too much effort has been invested in the Bank’s forecasting model which – like all the others in the field – is an elaboration of the Keynesian income-expenditure model. As this model has no role for the quantity of money to affect anything, it is wrong-headed and dangerous. I may be unusual in believing that its model adds little to the Bank’s thinking and should be de-emphasized, but my track record in forecasting big movements in inflation – over the last 40 or so years – has been much better than the Bank’s. The priority here should be for the Bank’s economists to integrate money into their modelling. Only a handful of good analysts – three or four at most – are needed, as a small team can work together as a team, share insights, point out mistakes and so on. But, to reach the right conclusions, they must have the right theory. Computer models with hundreds of equations are a waste of time.

Bernanke says that more attention should be paid to the “monetary transmission mechanism”. Yes, of course, as long as the monetary transmission mechanism is understood to be about the relationship between, on the one hand, the banking system and the quantity of money, and, on the other, macroeconomic outcomes. But this isn’t what Bernanke means by the phrase. What he intends is a supposed “credit channel”, in which the terms and availability of bank credit are far more important to the determination of national income and inflation than any money aggregate. (Bernanke has written many articles on the credit channel – and this work was cited in his Nobel commendation.) As I set out in one of two attached chapters of a forthcoming short book – to be called The Quantity Theory of Money: a New Restatement and published by the Institute of Economic Affairs in the next few months – a money-based account of the determination of national income and wealth is far more persuasive than a credit-based alternative.
 
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