The Iran War

What should the Bank of England do?

Just over a week ago I was going to write a post along the lines of ‘We shouldn’t be worried about inflation… unless Trump bombs Iran’. I didn’t have the time so I didn’t write it but Trump has bombed Iran. So, should we be worried?

I don’t want to wade into a discussion over the morality of the situation other than to say that I’m pleased that so many leaders of the evil Iranian regime have been eliminated and I hope that the country can move towards some form of democratic system and that the Iranian people will finally be free. I’m also not a war/defence/IR person so I don’t really have a clue how long this will go on for (although to be fair, I don’t think anyone knows the answer to this).

However, we have already seen oil and gas prices increasing in the UK and around the world. Even if it all gets sorted very quickly, we are currently in the midst of an oil shock. This may or may not turn out to be inflationary. You would be forgiven for thinking that an oil shock would obviously be inflationary given that its raised the price of something which households and firms rely on and has knock-on effects as it means manufacturing and delivering other goods is more expensive and it would be reasonable to expect that these costs are then passed onto consumers in the form of higher prices.

This is all correct, but things are a little more complicated than that. This is because although an oil shock will increase prices, it doesn’t mean that it’s inflationary. In much the same way that tariffs are economically damaging and raise prices, it tends to be a ‘one off’. In short, although the cost of living and doing business might be higher as a result (perhaps permanently) it does not mean that inflation will be persistently high.

This is one of the reasons why central banks shouldn’t respond to supply side shocks. Such shocks tend to be temporary and even when they’re not there is very little that central banks can do about it and when they try they tend to make matters worse.

Unfortunately for the UK, the Bank of England will likely muck it up (again). The market had priced in at least two interest rate cuts this year but now seems to expect none. Traders expect the MPC to panic and hold Bank Rate at its current level.

This would be a mistake. Economic growth is persistently weak, unemployment is up, vacancies are down, and we have almost one million young people not in employment, education, or training. This is largely a result of government policies such as the NICs hike, increases to the minimum wage, and the Employment Rights Act.

All of this points to inflation falling rapidly and returning to target before undershooting the Bank’s two per cent target. In fact, we could actually see a swifter fall in core inflation as a result of the oil shock with increased costs for households and firms placing even more pressure on jobs and weaker demand for other goods and services.

A lot can change between now and the next MPC meeting. However, as things stand, it would be inappropriate for the Bank to try and use monetary policy to ‘deal’ with the crisis. It should instead probably cut interest rates at the next meeting.

Now, at this point, you might be thinking ‘Team Transitory: where have I heard that before?!’ as your mind wanders back to the incredibly high inflation of 2022. I have some sympathy for this given that there are parallels between now and then given that they both appeared to centre around energy price shocks.

However, ‘appeared’ is the key word here. Although supply side shocks were a factor in the very high inflation of 2022, they were only partially to blame. Central banks around the world (including the Bank of England) were understandably nervous about increasing rates and ignored all the warning signs of increased demand such as the significant increase in the annual rate of broad money growth in 2021 and 2022. As a result, the MPC kept monetary policy inappropriately loose when the correct course of action was to tighten.

There is no ambiguity this time. The shock is coming from the supply side. Therefore, the Bank should look through this and continue to cut rates. As I’ve written before, three per cent is probably the neutral rate and is what the MPC should be aiming for by the end of the year.

If the crisis persists then the Bank may need to change course if the second-order effects do prove to be inflationary. In the meantime, it is for the government to respond by providing targeted financial support to low-income households who might be impacted by a spike in their energy bills. Ultimately it should stop its frantic rush towards Net Zero while making it far easier (and less expensive) to build energy infrastructure so that costs come down for firms and households.

It will no doubt be difficult for the MPC to cut rates this month given it does have a credibility problem due to its repeated failures and so it will be tempted to hold Bank Rate at its current level. This would be a mistake as it would further hamper growth and it would be a disaster for the prospects of young people. The Bank needs to Keep Calm and Carry On (cutting rates).

Thanks as ever for reading. I might write something else tomorrow — possibly on gilts, but right now I’m off to the National Maritime Museum.