Yahoo Finance What if Bank of England fails to control inflation?
The Bank of England has a mandate to keep inflation at 2% but with forecasts putting it at 10% in just a couple of months, an official has warned of the risks households face if the central bank gets it wrong.
Raising interest rates quickly may spare households an even worse squeeze on living standards, according to Bank of England policy maker Michael Saunders.
Saunders, who sits on the Bank of England's Monetary Policy Committee (MPC), voted for a 50 basis point rate hike last week, with the central bank deciding on a 25 basis points hike to 1%.
"I put considerable weight on risks that, unless checked by monetary policy, domestic capacity and inflation pressures would probably be greater and more persistent than the central forecast," he said in a speech at the Resolution Foundation think tank.
"As a result, my preference has been to move relatively quickly to a more neutral monetary policy stance."
The idea behind keeping inflation low and stable is to help everyone plan for the future. If inflation is too high or it moves around a lot, it makes it difficult for businesses to set the right prices and for people to plan their spending.
Read more: Bank of England raises UK interest rates and warns of 10% inflation
As the Bank of England sets interest rates — what it costs to borrow money — it can control how hot or cold the economy runs.
If the interest rates are low, making it cheaper and easier to borrow money, more spending will happen, which can cause prices to rise.
However, if the economy runs too hot and inflation sits much higher than the 2% interest rate, it can increase rates to slow down the price surge. Essentially, the higher the base rate, the more expensive it is for companies and individuals to borrow money.
Ideally, the Bank of England’s decisions ensure a 2% rise in the cost of living and, ideally, wages each year.
It’s considered a healthy rate of growth and means a reasonably consistent standard of living
But as inflation could exceed the central bank’s own forecasts which sees it topping 10% later this year, the Bank of England has to walk a tightrope as it tries to rein in inflation without pushing the economy into recession.
Saunders said the central bank faces two alternative risks. “One is that monetary tightening which is sufficient to lean against near-term inflationary pressures may exacerbate the prospective squeeze on activity and leave inflation well below target further ahead.
Read more: Sunak hints more support to deal with cost of living squeeze could be on the way
“The other is that if monetary policy does not adequately lean against inflation pressures, then we may see a prolonged period of above-target inflation that causes longer-term inflation expectations to become further detached from the 2% inflation target.
"That could ultimately require a sharper adjustment in monetary policy and the economy to return inflation to target, and result in an even worse outcome for real incomes and living standards.”
Saunders said the BoE should "lean strongly" against high inflation expectations because "the process of re-anchoring price expectations could be very costly in economic terms".
However, most members of the MPC fear raising borrowing costs risks choking off already weakened economic growth.
Moving slowly may also jeopardise the BoE’s reputation, he warned. “The MPC’s ability to use monetary policy to provide effective support to the economy in 2020 rested on the credibility of the inflation targeting framework. That credibility is not infinite and cannot be taken for granted.”
Saunders said he believes the risks of inflation becoming embedded in the psyche of businesses and consumers continue to grow, meaning the UK could face a period of protracted inflation.
"If monetary policy does not adequately lean against inflation pressures, then we may see a prolonged period of above-target inflation".
Read more: Is the UK heading into a recession?
He fears the impact of so-called secondary inflation adding to the problem down the track.
BoE governor Andrew Bailey has previously warned against wage rises which aim to match the pace of inflation.
If enough people are given a raise by their employer, or switch jobs in order to secure a higher wage, pay across the whole economy rises.
Businesses are forced to bear the higher costs of paying their workforce more, and that is priced into the cost of their services or produce.
This creates what economists call a wage price spiral where the more things costs, the more workers demand higher wages and then the more things cost again.
The UK’s consumer prices rose by 7% in the 12 months to March — a 30-year high
The Bank of England's new central forecast for CPI inflation stands at 10.25% for the year's end.
