The Bank of England has faced a growing tide of criticism that it risks being too slow in cutting interest rates having failed to respond quickly enough when inflation started to rise.
Critics of the Bank point to the fairly rapid descent in inflation over the past few months, which has surprised economists. They also point out that the UK is technically in a recession.
Andy Haldane, former chief economist at the Bank, is often seen as one of the leading advocates of this view.
“It’s one thing to have missed inflation on the way up, which happened. It’s quite another to then have crushed the economy on the way down,” he said.
This view is also popular among Conservatives who fear that excessive caution from the Bank could stymie a budding recovery just when the government needs to convince voters that its economic plan is working.
Conservative MP John Baron told Bank Governor Andrew Bailey last month during a Treasury Committee hearing that the economic warning lights were “flashing red” while “inflation is coming down, and coming down fast”.
“Why isn’t the Bank responding more?” he asked.
When expressed in isolation, it is a compelling argument. The UK is in a recession and inflation has come down fast, so why wait to cut rates?
However, neither of these things can be attributed with much confidence to the impact of higher interest rates.
Take growth. Despite the Bank’s aggressive monetary tightening, the recession seen at the end of last year was among the most shallow ever recorded.
We are now over two years through the tightening cycle, and it’s hard to believe that worse is to come. Indeed, interest rates have not budged for over six months and growth already appears to be recovering.
Rather than plunging the UK into a deep recession, higher interest rates appear to have had a fairly marginal impact compared to the terms of trade shock following the Russian invasion of Ukraine. That was the real cause of last year’s recession.
There’s an open question about how monetary policy has transmitted through to the wider economy in this tightening cycle, leading people like Archie Norman, chair of M&S, to argue that monetary policy is “totally ineffective”.
This may be going too far, but it certainly looks like interest rates have not been as potent as they have previously been.
Turning to inflation itself, there is no doubt that there has been significant progress. Inflation has fallen from over 11 per cent in October 2022 to just four per cent at the beginning of the year, but a very large portion of this disinflation simply reflects the unwinding of the energy price shock following the start of the Russia-Ukraine war.
Ben Broadbent, a deputy governor at the Bank, told MPs last month that “most of the disinflation we have had – in fact, all of it over the last year – has been in tradeable prices, on energy and tradeable goods.”
What price pressures remain are likely to prove much more stubborn.
Just look at the US experience. Inflation fell to three per cent last summer and has not gone below since. Last month it rose unexpectedly to 3.2 per cent, raising the risk that inflation could permanently settle at a higher level.
Domestic pressures remain substantially more elevated in the UK than in either the US or eurozone thanks to the tightness of the labour market.
Unemployment is actually lower now than last summer, which is helping to fuel strong wage growth. Although wage growth is on its way down, the Bank has said there hasn’t been enough progress to be sure that inflation will fall sustainably to its two per cent target.
Wages are the key determinant for services inflation, which currently stands above six per cent.
Higher wage growth also means households get a substantial real income boost when inflation falls, pointing to a dilemma facing the Bank. The closer inflation gets to target while wage growth remains high, the more spending power households have which, in turn, could fuel another round of inflation.
For now, markets currently estimate the first rate cut in the UK will come in the summer.
While there’s no doubt that cuts should start by then, it might be wise to wait a little bit longer before reaching for the interest rate axe.