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The Inflation Dragon Is Slain: Time To Cut Interest Rates And Taxes

UK inflation to top Bank of Englands 2 target until end of 2024
Written by Robert Lee

UK inflation is set to fall sustainably to or below the 2% target level. The Bank of England should cut interest rates and end QT, and the Chancellor should cut taxes that boost the supply side of the economy. This would restore much needed economic growth and avert unnecessary economic and social pain.

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The BoE should start reducing Bank Rate at the next MPC meeting

Bank of England (BoE) Chief Economist Huw Pill has stated that the Bank can’t yet reduce interest rates because there is “only modest and tentative” evidence that UK inflation is coming back to target. Two of the nine members of the Monetary Policy Committee (MPC) voted at the January meeting to raise interest rates. I’m afraid the BoE is once more badly misreading the tea leaves, because the evidence that inflation is sustainably coming back to target is not tentative but compelling:

  • The spike in UK inflation to a peak of 11.1% in October 2022 was facilitated and triggered by the BoE’s panicked reaction to the Covid lockdown – which caused broad money supply (M4) to grow by 15% in the year to Q1 2021 – and by its tardy initial response to the consequent rise in inflation. However, in the three years since then annual M4 growth has averaged only 2.5% and has been negative over the last twelve months. Such sustained low money growth is simply incompatible with inflation remaining above the 2% target; indeed, it implies that inflation will probably move below target. Money growth is now notably lower than it was in the ten years before 2020, a period in which inflation averaged just under 2%.
  • The annual UK inflation rate has already fallen sharply from its peak, reaching a recent low of 4% in January. What is less commonly realised is that the inflation rate in the last seven months has been zero! No, that is not a misprint. The UK Consumer Price Index (CPI) was no higher in January than it was in June. This is not a surprise to economists who take money growth trends seriously but has been a surprise to Bank officials who – absurdly – do not.
  • Very sharp falls in UK natural gas prices in the last five months – down more than 50% – mean that there will be significant reductions in the energy price cap in both April and July. This factor alone virtually guarantees that the annual inflation rate will fall below 2% in the next few months.
  • Bank officials are aware of this but claim that the level of wage rises is still too high to be sure that inflation will not rebound above target again later in the year. It is true that the annual rate of wage inflation of around 6% is not compatible with 2% inflation but pay data from the HMRC (admittedly an experimental data series) shows that average monthly pay levels have shown virtually no growth in the last six months. This is consistent with a stagnating economy (provisionally estimated to be in “mild recession” in H2 2023), greatly reduced price pressures, a marked fall in job vacancies (down 30% since May 2022) and a sharp rise in company insolvencies to the highest level since 1993.
  • Producer prices tend to lead consumer prices by a few months. UK producer price inflation has been negative for more than a year and shows no sign of reversing back up, particularly with the £ trade-weighted index having risen by 5% in the last year. The Bank has raised alarm about possible prices increases due to the supply chain problems resulting from attacks on ships in the Red Sea area. However, monetary policy should not react to short term price changes that are due to supply disruptions, as these are typically one off and not part of a sustained inflationary process.
  • Policymakers should also be aware that a wave of deflation from a parlously weak Chinese economy is on its way. Producer prices in China have already fallen by 5% in the last year while Chinese export prices are down 12% in $ terms. These downward pressures are likely to continue. Dramatic progress in AI, robotics, stem cell research, clean tech, bio science and other breakthrough technologies is another powerful deflationary force.        

It is clear from this evidence that the BoE has won the battle to bring inflation back to target and is now inflicting unnecessary damage to the economy and society by maintaining Bank Rate at the current level of 5.25%. It should begin by cutting Bank Rate by 0.5% at the next MPC meeting. Since monetary policy acts with long lags the previous tightening of policy will still be exerting downward pressure on money growth and inflation for some months. How low could Bank Rate go? If inflation does settle at or below the 2% level a reasonable range for Bank Rate could be in the 3.25-3.75% range by mid-2025. This would provide significant relief to the economy but still keep short term rates positive in real terms. The Bank should also immediately end its quantitative tightening (QT) programme, in which it sells government bonds from the stockpile purchased in its ill-advised money printing exercises. The Bank can reduce its bloated balance sheet more slowly and steadily by simply not replacing bonds as they mature. Ending QT would assist in reducing longer term bond rates to lower levels along with Bank Rate.

Economic Recovery should also be supported by Supply side Tax Cuts

An environment of controlled inflation and lower interest rates also has significant implications for fiscal policy. Lower forecast interest payments on government debt, and improved growth prospects would enlarge the “fiscal headroom” available to the Chancellor. This headroom should be used to boost the supply side of the economy and thus help ensure there is no return to higher inflation. The BoE have constantly re-iterated their concern about the staggering rise post-Covid in the number of people of working age no longer making themselves available for work. This reduces the economy’s potential growth rate and makes the economy more vulnerable to higher wage inflation in a recovery.

The reasons for this rise in the workless are no doubt varied and complex, but a first-year economics student could tell you that if you tax work more you will get less of it. By raising benefits with the inflation rate but freezing tax thresholds the government has markedly increased marginal tax rates, particularly for lower income workers. The Chancellor should therefore reduce taxes on income in the forthcoming Budget. Other supply side reforms, perhaps in the Autumn Statement, could include a reduction in the company tax rate and/or ensuring that the full expensing of investment allowances previously announced spreads to small companies. The spread of investment assets that qualify should be widened as the current classification is too narrowly focused on plant and machinery. Other possibilities include the reduction or abolition of taxes that inhibit trading in crucial markets, such as stamp duty on houses and shares.

Conclusion

By slaying the inflation dragon, a window of opportunity has opened for policymakers to assist the economy to return to growth, the only way to help solve many of our myriad social and economic problems. Will the current leadership in the Bank and the Treasury have the courage and imagination to seize it? There is no need to fear a Truss-style bond market meltdown as the suggested policy changes are in line with strong global and domestic trends. However, don’t hold your breath. One can always hope, so I leave the last word to former BoE Chief Economist, Andy Haldane:

“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. That double blow to credibility is one if I were a central banker, in my old job, I would be looking to avoid”

Robert Lee

February 21st 2024

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About the author

Robert Lee

Robert Lee is an economic consultant and private investor.