Not Our Job to Prevent Recession (1): Bank of England

The Bank of England’s inflation mandate virtually guarantees recessions as higher interest rates repeatedly puncture house-price booms. What are higher interest rates meant to achieve right now as we already head into recession? Why hasn’t the Bank done more to prevent house price booms? Should additional regulatory levers be introduced?

When he announced the independence of the Bank of England (BoE) in 1997, Gordon Brown famously declared it would mean the end of “boom and bust”. He was forced to swallow his words in 2008, of course.

BoE independence has not prevented irrational exuberance in the UK housing market in particular. As Fig 1 shows, though, this can lead to unaffordable mortgages when interest rates rise:

We’re already heading into a recession because energy prices are reducing demand. This wouldn’t be a problem if wages and benefits were keeping pace with inflation, as I’ve previously called for, but they aren’t.

Increased mortgage costs will exacerbate this.

Why is the Bank of England raising interest rates?

So why is the BoE insistent further rate rises are necessary “despite the pain this will cause to households and firms”? Their website explains:

Higher interest rates mean people borrow less and spend less. So the economy slows down and companies can’t put their prices up so quickly. We know that higher rates will be hard for people. But it’s better for everyone in the long run to have low and stable inflation. We need to raise rates to achieve that. Otherwise, the problem will get worse and, in the end, we’d need to raise interest rates by even more.

Fig 2, BoE website response to FAQ “Why will higher interest rates bring down inflation?”

But the economy is already “slowing down”! People are already having to “spend less” because of exorbitant energy prices and the fact that wages aren’t (in general) keeping pace with inflation! The economy is (at best) close to flatlining already!

Are we suffering from a form of madness? Have we completely stopped thinking? Are we blindly following a policy prescription for the 1970s and not the 2020s?

The difference, of course, is that the labour market (and the regulation of collective bargaining) is unrecognisable from the 1970s. There are simply no signs of a wage-price spiral. The government is moreorless ignoring the strikes that are occurring.

The weak pound

Besides “slowing the economy”, raising interest rates also defends the pound, by attracting speculative flows or investment.

If the pound falls then this feeds inflation.

So there is a sense in which the Bank of England’s hands are tied. Central banks around the world tend to act in unison to protect their currencies.

But is this really necessary? After all, long-term the value of currencies is determined by the competitiveness of the economy.

Richard Murphy, in collaboration with Danny Blanchflower, recently questioned in a long Twitter thread whether it is necessary to raise interest rates to protect sterling:

“…we changed from a policy of ‘Protect the pound’ to one of ‘Protect the people, their homes, their children, and public services’, or ‘Protect people’ for short. Getting off the gold standard helped in the 1930s. Changing the goalposts now would have the same effect. This changed the way we looked at issues. So we immediately relaxed some of the assumptions that we think the Bank of England might prioritise at present. So we decided we would not stop the pound from falling to parity with the dollar, or try to keep inflation to 2%. As a result we decided to just let the pound float. That might be inflationary, and maybe it will not: it’s very hard to tell. But we decided it was not worth sacrificing the well-being of people to keep the value of the pound above $1, which is a financial vanity project.”

Fig 2: Excerpt from Twitter thread by Richard Murphy on 30/9/22

Of course, the exchange rate is only an issue at all if the UK is a policy outlier. Perhaps other central banks (such as the ECB) should also consider whether steep interest rate rises are really necessary right now.

Current inflation is a temporary problem

There is no reason to expect the inflation we are experiencing in the UK at the moment to be persistent and every reason to expect it to peter out.

As I’ve already mentioned, wage rises are not in general keeping pace with inflation. We are not in a wage-price spiral. It is not the 1970s. Of course, rising energy prices spill over into the prices of many other goods and services, but this will only continue so long as energy prices rise.

There are some labour and skills shortages in the UK economy, scars from Brexit and Covid. But with the economy already flat-lining (at best) these shortages will not worsen, which would be necessary to fuel inflation.

And, critically, the Truss government has capped domestic energy prices for two years from 1st October 2022. The direct contribution of energy to inflation indices from 1st October 2023 will be zero. At most. The contribution could be negative, because it’s a price cap and energy prices could conceivably be falling by then.

What the Bank of England is planning to do by raising interest rates is to increase inflation in the short-term, by raising housing costs, in order to slow an economy already close to recession, in order to prevent a purely hypothetical wage-spiral spiral.

The Bank is making a category error.

An aside: what determines mortgage rates?

Mortgage rates aren’t generally determined by the Bank of England’s base rate, but by money-market rates.

Sure, if you’re on a Standard Variable Rate (SVR) – which I see is now (confusingly, possibly intentionally so) likely to be called something else depending on your bank – rather than a fixed period deal, then the interest rate you pay may well be based on the BoE base rate.

But if you’re on a fixed rate this will be determined by money market rates. After all, why would a bank lend to a homebuyer (who might default) at a lower interest rate than they can get by lending to the government (the so-called “risk-free” rate)? So you do have to worry about those gilt prices.

However, the BoE also controls money-market rates. In fact, that’s the whole point of the base rate in the first place. Logically, and sometimes in practice, they should intervene in the money markets to bring rates down to the target. It follows that, rather than the planned Quantitative Tightening (QT), the Bank might need to do more Quantitative Easing (QE). This is also proposed by Murphy and Blanchflower:

“This is quantitative easing (QE), of course, and unashamedly so. We have a national emergency. We proved in 2009, 2020 and 2021 that QE is needed to address crises. We’d do it again.”

Fig 3: Excerpt from Twitter thread by Richard Murphy on 30/9/22

Murphy and Blanchflower suggests QE to explicitly fund a government deficit spending programme. I suggest the objective of QE should be to stabilise money market rates, continuing what is already happening following the operation to save certain pension funds from the speculative attack that followed Kwarteng “mini-budget” of 23rd September.

I’ll address what the government should be doing in another post.

But the BoE hasn’t unwound the existing QE!

Irrelevant. We are where we are, although we do need to review the mistakes that have been made.

Now is simply not the time to unwind QE as the BoE has proposed. And more QE may be necessary to manage mortgage (and other) interest rates.

The fact that raising interest rates now is simply going to make the coming recession worse doesn’t mean house prices aren’t too high, or interest rates too low. We shouldn’t be in this situation in the first place. We should never have had unprecedented, ultra-low interest rates over the last decade or so (see Figs 4 and 5), which have led to the current housing boom.

Changing the BoE remit

If the UK experiences a deep recession, accompanied by a housing market crash – as is highly likely – this will be in large part because the UK government (and the Bank of England) have (once again, see Fig 1) allowed house prices to reach an unsustainable level.

Failing to recognise the need now to deflate the housing market gently only compounds the problem.

Surely after 1989, 2008 and now 2022 we need to devise a set of policies to ensure house prices are much better controlled.

The Bank of England might not have all the policy levers to manage house prices on the way up, but it does have a remit (I understand) to ensure financial stability. For example, Mervyn King (in common with some other central bankers) bizarrely interpreted this as requiring the “punishment” of banks to somehow prevent “moral hazard”, rather than acting as lender of last resort, thereby worsening the financial crisis which caused the Great Recession. A large part of the problem, then as now, was a house-price bubble.

Perhaps the Bank of England remit needs to specifically include preventing house price bubbles in the first place. Perhaps, rather than delegating too much economic management to the Bank, this could be done in cooperation with the Treasury and other regulators. At a minimum, we should never repeat the unprecedented ultra-low interest rates seen since 2008 (see Figs 4 and 5).