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Anyone would think the Bank of England’s failure to grasp the inflationary nettle was deliberate

The Bank of England has been accused of hopelessly misjudging inflation – and even playing a key role in nurturing it
The Bank of England has been accused of hopelessly misjudging inflation – and even playing a key role in nurturing it - CHRIS RATCLIFFE/Shutterstock

Jeremy Hunt, the Chancellor, doesn’t like to admit it, but today’s way above target inflation has for him proved a blessing in disguise, riding to his rescue in last week’s Autumn Statement by giving the Government scope both to cut National Insurance contributions and make big tax breaks for investment spending permanent.

The resulting £20bn tax “giveaway” would not have been possible within the parameters of the Government’s own fiscal rules, but for the fact that high inflation has put rocket boosters under expected tax revenues, especially those resulting from the “fiscal drag” of freezing personal tax thresholds.

With fast-rising nominal earnings, the effect is to draw millions into higher-rate tax bands, or into paying tax for the first time, boosting receipts by more than £40bn a year by the end of the forecast period, far more than was originally anticipated.

When assessing the impact of inflation on the public finances, there is a distinction to be made between imported inflation resulting from external economic shocks – in this case the pandemic and energy prices – and domestically generated inflation in the form, mainly, of rising wages.

The former type of inflation, adversely changing the terms of trade, is unambiguously bad for the public finances – public spending goes up, but tax revenues remain the same. But in the latter case, it can be helpful in that it adds to tax revenues and helps inflate away the size of the national debt.

We shouldn’t doubt the Chancellor’s sincerity when he says the Government’s number-one priority is to get inflation back to target, but the windfall of fiscal drag has proved a godsend nonetheless.

The other positive is that by increasing the size of the denominator – the total value of the economy – inflation naturally helps erode debt relative to GDP, thus again helping the Government meet its fiscal rules.

Inflation works both ways on the public finances, of course.

Debt servicing costs and welfare payments will also be much higher than otherwise, but by pencilling in a little austerity, the Government can easily make the positives – in terms of meeting the fiscal rules – outweigh the negatives, without having to go full tonto and make dramatic nominal cuts to public spending.

In order to make the numbers add up, the Chancellor has assumed little or no rise in departmental cash spending for the next five years, but it would have been much worse if inflation had remained at or close to target.

As it is, even the degree of the spending freeze Hunt has pencilled in will be a struggle. Few forecasts are ever met precisely, if only because events intervene.

The Chancellor will be hoping either that things turn out better than predicted, so he won’t have to apply the thumbscrew quite so forcibly or that, with an election looming, it will soon be somebody else’s problem anyway.

All of which brings us to what for the Tory Right are two of the three bête noires of Britain’s institutional framework for managing the economy – the Bank of England and the Office for Budget Responsibility (OBR). The third, the Treasury, is a subject for another day.

For the Bank, the charge is that it hopelessly misjudged inflation, and indeed played a key role in nurturing it with the money printing of quantitative easing. For the OBR, it is that likewise it gets its forecasts woefully wrong and therefore acts as an unnecessarily constraining and contractionary force in the UK economy.

On the OBR, the case for the prosecution is I think pretty weak. It’s perfectly true that the establishment of the OBR was part of a much wider European austerity agenda, when nonsense ideas that contractionary fiscal policy could actually be expansionary abounded.

But if the charge is that the OBR is contractionary in its impact because its forecasts are too pessimistic, in fact the opposite is true. Recent GDP revisions by the Office for National Statistics, which were a revelation to everyone, slightly change the picture, but not by much.

On the whole, the OBR has to the contrary consistently been too optimistic.

If there is a contractionary bias in the OBR’s various pronouncements, it is in any case not the OBR itself which is responsible, but the Government, which binds its own hands by setting the sort of fiscal rules deemed necessary to keep the bond vigilantes at bay.

We saw what happened when the Truss government decided to dispense with the OBR’s services, knowing that what it was trying to do would break the rules. It didn’t end well.

What’s more, if there is a Labour government coming, the guardrails the OBR applies to ensure fiscal discipline acquire even greater importance. It was in response to the profligacy of New Labour, when the fiscal rules were manipulated to destruction, that the OBR was set up in the first place.

If governments want a more pliable OBR, they should set easier fiscal rules, which come to think of it, are already so lax that they invite fantasy policy anyway.

I’m quite sure Truss could have made her tax cuts meet the rules by pencilling in policies for the future that never stood any chance of being implemented. Yet had she done so, everyone would have seen straight through them.

At least we now have a proper debate about the public finances, and full transparency. Prior to the OBR, the process was entirely opaque. It was hard to know what was going on beneath the bonnet.

The case against the Bank of England is more easily made, and indeed is well explored in a report this week from the House of Lords Economic Affairs Committee, called Making an Independent Bank of England Work Better.

As the committee points out, “high and persistent inflation since 2021 is in part due to supply shocks brought about by the Covid-19 pandemic and Russia’s invasion of Ukraine.

“Nonetheless, the persistence of above-target inflation over this period also reflects errors in the conduct of monetary policy, including an over-reliance on inadequate forecasting models.

“We do acknowledge that the Bank of England is not the only central bank that failed to anticipate high and persistent inflation. This may be partly explained by a sense of complacency about inflation among all major central banks given the prevalence of low-price pressures over the last decade or so”.

The committee’s key point is that errors in monetary policy may have reflected a lack of diversity of view in the Bank of England and central banking more generally.

We are all too painfully aware of what happened: the grand mufti of central banking assumed that the incoming wave of external shocks would be transitory, and it was therefore reasonable to “look through” their inflationary impact – ie. ignore it altogether – in the expectation that things would soon return to normal.

There was a comprehensive failure to anticipate the second-round effects. Many of us warned at the time that regardless of the reduced power of the unions relative to previous inflationary periods, wages were likely to follow prices upwards – but we went largely unheeded.

It is I suppose just one of those curiosities that this very same wage inflation has helped support debt to GDP ratios at levels the markets find just about tolerable without recourse to the sort of punishing levels of austerity we saw in the early 2010s.

A more conspiratorially inclined person than me might even conclude that allowing the inflationary genie to escape its bottle was deliberate. So much for central bank independence.

This article is an extract from The Telegraph’s Economic Intelligence newsletter. Sign up here to get exclusive insight from two of the UK’s leading economic commentators – Ambrose Evans-Pritchard and Jeremy Warner – delivered direct to your inbox every Tuesday.

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