The Bank of England got it Wrong Again

The government isn't helping

Earlier today the MPC of the Bank of England announced its decision on interest rates. As expected it decided to not lower Bank Rate. This was the wrong thing to do. Although inflation is slightly above target, this was not surprising and is expected to only be a temporary blip before returning to and then overshooting the Bank’s target of two per cent. This, combined with low business and consumer confidence, means that the economic growth is going to continue to stagnate.

I have been critical of the MPC for allowing inflation to get out of control by keeping monetary policy to lose for too long and for then overcorrecting by tightening monetary policy by keeping interest rates too high for too long. It should have started loosening monetary policy over a year ago and even though it has finally started to lower interest rates it has been far too timid in its approach.

However, we must keep in mind that the MPC has an incredibly difficult job. If inflation is higher or lower than two per cent then it is deemed to have failed in its task but it also has to take into account the fact that its actions can have a negative impact on economic growth, mortgage rates, and the employment prospects of our fellow citizens. It has to do all of this with quite blunt tools and often based on deeply flawed and incomplete data.

As difficult as the task faced by policy makers at the Bank is, things were looking up. Inflation had returned to around its mandated target, growth remained disappointingly low but without any sign of a major downturn, and so it was able to get on with the more pleasant task of starting to cut interest rates. This was until the new Chancellor of the Exchequer stood up to deliver her first Budget.

Rachel Reeves and her team were savvy enough to trail many of the policies well in advance and they did not sideline the OBR and they generally did a good job at communicating what they were doing and why. As such, Labour’s first budget in over 14 years has not met the same fate as the disastrous mini-budget of Liz Truss and Kwasi Kwarteng.

Despite all of this, the markets rightly did not believe that tax changes announced by Labour would raise nearly as much revenue as they claimed or that the economy would grow at the rate needed to sustain even current levels of public spending. Labour has effectively broken its Manifesto promise to not increase the three main taxes on working people by hiking Employers’ National Insurance Contributions. This is a tax on working people as the incidence falls on employees in the form of lower wages and fewer job opportunities. If real wages don’t increase or if more people are out of work then economic growth takes a hit and the Treasury is unable to raise as much money in taxes. It’s a similar story with the hikes to Capital Gains Tax. Increasing the rate might make it look as though a government is being fiscally responsible but in reality it stops firms from growing and dampens productivity growth. This is all without taking into account the damaging impact that the Workers’ Rights Bill and the huge increase to the National Living Wage will have on employment prospects.

Moreover, while Reeves was right to trail many of her policies before the Budget so that markets were not too spooked, the communications from Reeves, Starmer, and the rest of the Cabinet in the months leading up to the Budget were incredibly damaging. The constant negativity about the economy undermined business and consumer confidence and so it is hardly surprising that growth has been non-existent since Labour came to power.

Reeves’ Budget and Labour’s pessimistic talk about the economy mean that both economic growth and the Treasury’s coffers will take a hit. There will be far less money to fund the government’s financial commitments. The difference will have to be filled by increased borrowing. The financial markets know this and so this and so the cost of borrowing for the government has gone up.

This, given all of the uncertainty in the Middle East and the fact that Donald Trump has been re-elected as President of the United States means that the MPC will be far more cautious about cutting interest rates. This is further bad news for the UK economy which will not only take a hit from the Budget but will also suffer because interest rates will remain higher than they should be.

Rachel Reeves was far too reckless with her first Budget and was wrong to spend the months preceding it undermining business and consumer confidence. Not only are many of the policies announced damaging by themselves, they have also made the Bank of England’s job even more difficult. Interest rates will remain higher for longer, economic growth will remain low, borrowing will increase, and it will be ordinary hard working people who suffer the most as a result.

Thanks as ever for reading. I might write something before Christmas (probably over analysing a Festive film) but we shall see.