Is the Bank of England to blame for the UK’s current inflation episode?

Gauri Khanna

Inflation, defined as a sustained increase in the general price level in an economy, has been escalating worldwide since mid-2021 with many countries’ consumer price indices surging well above 3% in 2022; in July, CPI in the UK reached 10.1%, the highest in 40 years since the period of UK stagflation during the 1970s and 80s. The usual culprits of high inflation in the media are international events such as the COVID supply-chain disruptions and public-health related labour shortages, the post-pandemic demand spike and more recently, the supply shocks resulting from Russia’s war in Ukraine. But central banks, like the Bank of England (BOE) have a mandate to maintain price stability within their 2% +/- 1 target - so why has the BOE failed to do so in the UK? And to what extent are they to blame for our country’s current inflation episode?

During the COVID-19 pandemic, the UK’s economy experienced its largest recession since the Great Depression of 1929. With lockdown measures in place, the ‘stay-at-home’ economy was faced with a combination of negative supply-side and demand-side shocks; both its capacity to produce goods and services and consumers’ willingness and ableness to buy these products fell drastically.

In response, the BOE implemented two major policies to avoid amplifying the 2020 recession. Firstly, the monetary policy committee reduced their base rate by 65 points to 0.10%. This form of expansionary monetary policy was carried out to boost aggregate demand by reducing the cost of borrowing and encouraging people to take out loans and mortgages from financial institutions. The second measure pursued was quantitative easing- the BOE purchased over £400 billion (thus increasing the money supply by 22%), in government bonds, treasury bills and other securities in the open market to provide liquidity to the financial system and support consumer demand. This in turn bid up the price of such securities, lowering yields for investors and encouraging them to invest in riskier assets that help boost the capital market. The policy also helped keep interest rates low as other banks sought to provide customers with competitive rates on loans.

To evaluate these methods of control, on one hand, it seems that the BOE in 2020 acted quickly to maintain an appropriate flow of credit in the UK economy and incentivise banks to keep lending to consumers in spite of the COVID recession, thus preventing the aggravation of the economic downturn from the pandemic.

However, due to the current high levels of inflation, critics of the COVID-period monetary policy, like the ex-BOE governor, Mervyn King, blame the scale of the increase in money supply through quantitative easing and low-interest rates for the general price level hikes we have seen over the past months. He likely supports the quantity theory of money, in this case, the idea that although supply chain shocks were the initial drivers of inflation, ultimately, increasing the money supply to a level greater than the quantity of goods and services (output) in an economy is what has caused the continuous high inflation of today since there is too much money available to buy a similar amount of goods and services.

Following the supply-side and demand-side shocks of the COVID pandemic, Russia’s ongoing war in Ukraine escalated into a mainland invasion in February 2022, and intensified the hit to UK supply chains, notably driving up energy and food prices as a result of the trade restrictions from economic sanctions imposed on Russia.

The BOE responded to these negative supply shocks by raising interest rates to dampen aggregate demand and attempt to control price levels; it initiated this in late 2021 when the base rate was increased from 0.10 to 0.25% but has continued hiking rates aggressively in 2022.

Critics of the policy of increasing interest rates, which is largely suited to mitigating the inflationary pressures from positive demand shocks, would argue they are not useful in combating the aforementioned negative supply-side shocks; rather, higher rates diminish business confidence, make firms less likely to carry out riskier purchases and invest in capital, and thus aggravate existing supply issues. In addition to this viewpoint, some argue that central banks’ priority of controlling inflation has pressured them to overreact when increasing interest rates, despite price instability being a mostly supply-side problem; this ignores the second mandate of independent central banks like the BOE, which is to support general macroeconomic objectives like economic growth and low unemployment, which are negatively impacted in the long-term by rapid rate hikes.

However, supporters of these rapid tightening policies from late 2021 may argue that they are necessary to reduce the money supply in the global economy to lower inflation, particularly as post-COVID pent-up demand is still prevalent in many industries such as travel and tourism. They would add that central banks generally have somewhat of a ‘blunt toolkit’; they cannot control supply-side policies to increase an economy’s productivity and efficiency in the way governments can- the latter can engage in free-market or interventionist policies to shift aggregate supply.

In conclusion, it is evident that there are varying stances on the extent of the BOE’s culpability for the current inflation episode. Given that this episode, from mid-2021 to 2022, initially came about due to massive supply shocks to the global economy, those who have praise for monetary policy in the last couple of years emphasise that the central bank has less power over price stability than is generally assumed and that the main policy tools to control inflation (raising interest rates and increasing the money supply) are effective only against positive demand-side shocks. However, I feel it is important not to overlook the scale and intensity with which the BOE carried out quantitative easing during the COVID-pandemic and continued asset purchases after the economy had regained strength, thus, according to the monetarist’s view, increasing the money supply well beyond the quantity of output. Alongside the policy of slashing interest rates aggressively to decade-lows, this resulted in the demand spike after the pandemic being amplified and adding to demand-pull inflation in the UK. More recently, the hasty hiking of rates in 2022 in response to solely supply shocks like the Russia-Ukraine war, was in my opinion, not entirely necessary nor effective, and increases of fewer base points could’ve been carried out to safely reduce aggregate demand without the risk of hurting economic growth in 2023/4.

Hence, whilst I acknowledge the convenience of hindsight when criticising the scale and rate of various monetary policy decisions, I believe, despite enacting the correct policy tools to support the economy at different times, central banks could have done so less vigorously and with more foresight as to the future impacts (or lack thereof in instances of purely supply-shocks) of their decisions on the inflation rate. This, I would argue, makes them blameworthy to some extent for the current inflation episode.