MNI INTERVIEW: BOE’s Only Option Gradual Tightening – NIESR

The Bank of England may have to keep interest rates higher for longer than policymakers appear to expect to dampen inflation, but it has missed its opportunity for aggressive tightening, National Institute of Economic and Social Research Deputy Director Stephen Millard told MNI.

The MPC could have hiked rapidly when the economy was recovering well from Covid but with recession risks now high it will have to move gradually as it tries to head off inflation pressures. Millard, formerly a senior research manager at the Bank, believes that Bank Rate may end up staying higher for longer than policymakers appear to believe.

“A year ago, the MPC could have gone very aggressively, and it would have been okay and interest rates would be much closer now to where they should be, The issue is that if you do that [raise rates aggressively] now you could send the economy into tailspin,” Millard said.

“That is why they have to adopt a gradualist approach. I don’t think they really have any choice in it,” he said in an interview.

R-STAR HIGHER THAN ASSUMED

At its May meeting, the MPC was split between the majority backing a 25-basis point hike and three opting for 50 bps, with Chief Economist Huw Pill subsequently driving home the case for gradualism. Market curves have shown Bank Rate rising from its current 1.0% to as high as 2.5% before falling back but Millard reckons the likelihood of it having to stay at 2.5% or above is understated.

The NIESR’s Spring forecasts showed the UK heading into technical recession later this year, on the assumption Bank Rate will flatline at 2.5%.

“That reflects our view as to where the natural rate, R-star, is. We have a sense that it is higher than where the Bank thinks it is, and having got interest rates up to more normal levels that seems a better place to be,” he said.

Millard supports the Bank’s view that the highly uncertain level of R-star, the level compatible with stable inflation and output, should not drive policy setting but does determine where rates will end up. (See MNI INSIGHT: R-Star Falls Out Of Favour As BOE Tightens)

“I would never set policy according to what I believe R-star is. I would always think ‘Okay, where is inflation going, where do I need to put interest rates now to get inflation back to that 2% target?” he said.

FISCAL SUPPORT NO MONETARY GAME-CHANGER

Amid intense speculation that the Treasury will soon step in with fiscal support to try and ease the cost-of-living crisis, perhaps by means of a rumoured cut in value-added tax, NIESR has advocated raising benefit payments to help the least well-off.

But Millard sees none of these measures as game changers for monetary policy. Increases in benefits would have only a marginal effect on inflation and policymakers would be likely to look through VAT cuts, whether temporary or not, to combat underlying inflation pressures.

A temporary VAT cut to deal would lower near-term headline inflation but an MPC member “would be thinking ‘Okay, I am getting this nice picture that inflation has suddenly dropped but I am going to have to deal with the fact that it will go up later. So over that medium term then I am essentially still having to do the same policy as I was before,” Millard said.

“This is a supply shock and one of the basic things about monetary policy is demand shocks are easy to deal with, supply shocks are a lot harder because you do have that trade-off between the effects of your policy on output and the effects of your policy on inflation. And that just makes monetary policy quite hard and that is why I think the gradualist approach is the right one,” he said.