The Bank of England’s Christmas present to the economy in 2021 was the first post-pandemic interest rate hike amongst large, developed economies.
Back then, the clever clogs at Threadneedle Street expected inflation to peak at 6% in April 2022. By that time, inflation had hit 9%, and it didn’t peak until six months later, at almost double the predicted level.
Caught out behind the curve even more than usual, the Bank of England responded with a truly unprecedented series of interest rate hikes. If we take the December 2021 Bank Rate of 0.1%, interest rates have now risen 4,500%.
The impact on borrowers has been devastating. Especially for landlords. Mortgage rates have more than quadrupled. Borrowers face multiples higher interest payments. And renters are complaining about rent increases a fraction of this rate, while wondering why housing supply is lacking.
All this begs the question why the hell my headline says, “Here come higher interest rates, at last”. The answer is quite simple. The impact of higher interest rates has barely begun.
Central bankers have long known about and studied the phenomenon of monetary policy lags. You see, when they manipulate interest rates, it takes time for this to actually reach the economy.
How long? Estimates vary wildly between one year and two. Which, of course, takes us back to when the Bank of England began hiking rates 17 months ago. My point being that the impact of those initial hikes has only just begun.
The bulk of the rate hikes haven’t even had their impact yet. Interest rates have only been above 2% for eight months, for example. A year ago, the rate was 1%. Today it’s four and a half times higher…
What about inflation coming down already then? Well, a good chunk of our inflation was prices rising in response to an energy shock. That shock, also taking time to make its way to consumer prices, does eventually peter out.
To the extent that the shock is a permanent shift to a higher level of prices, its impact on inflation should peter out to zero, because inflation is a measure of prices rising, not of high prices.
If the shock is, however, temporary, then it should actually push prices down again as it passes.
I don’t know which of the two boxes the energy price shock belongs in. Either way, the shock’s waning impact on inflation is likely to be behind inflation moderating.
It’s also worth remembering that there are plenty of other things going on that move prices, such as vast QE, lending, currency moves and government spending.
But my point is that the impact of tighter monetary policy is barely beginning… just when we don’t really need it as much anymore because inflation is slowing anyway.
Sure, inflation is still some multiple of the Bank of England’s target. But today’s monetary policy won’t address that problem for another 18 months, by which time… who knows what inflation will be.
Indeed, with inflation coming down fast over the past few months, are central bankers regretting increasing rates 4,500% in 17 months? Would they hike that much today if their monetary policy didn’t have such a long lag? I doubt it, in the face of bank failures in the US and bond market wobbles in the UK.
In fact, it seems more than likely that central bankers have overreacted again. Despite being aware of this monetary policy lag, central bankers invariably over tighten and over loosen monetary policy in each cycle. It’s tough to stand there doing nothing for 18 months while you wait for your monetary policy medicine to kick in, after all.
This is what gives the economy its boom and bust cycle – central bankers overdoing and underdoing interest rates. Which is ironic given their job is to mitigate that same boom and bust cycle.
It’s much the same problem as in commodities, which is why we have a commodity cycle. High prices lead to overinvestment in mining, leading to a glut, leading to low prices, leading to underinvestment, leading to a shortage, leading to high prices, and then the cycle repeats.
The delay has the same effect as those drunk driving goggles which police make school children wear to learn the effects of alcohol on their ability to drive. “Central bankers’ fatal vision goggles” probably would’ve made a better headline too…
Of course, this idea of monetary policy lags is not cutting-edge stuff. It’s just that human nature keeps making the same mistakes even though we know about the consequences. People still drink and drive.
And so we now have warnings about a new mortgage shock, spiking inflation and banks are raising interest rates in anticipation of more of the same from the Bank of England. Central bankers are hiking their way into a 2008-style crisis, again.
Central bankers’ powerful response to the very real problem of monetary policy lag has been hilariously theoretical. They argue that people’s anticipation of higher interest rates helps quash inflation. If we believe inflation won’t persist, it won’t happen in the first place.
Szu Ping Chan and Melissa Lawford describe the idea, over at the Telegraph:
Prepare for pain: Britain is hurtling towards a new crisis
Homeowners and businesses will pay the price for the Bank of England’s King Canute moment
The idea behind the story is that the Bank of England thinks it can stem the tide of inflation by bringing down inflation expectations by way of promising to hike interest rates sufficiently.
Presumably, this avoids the problem of monetary policy lag and the chaos it causes by avoiding the need for the promised interest rate hikes. If inflation comes down in anticipation of those hikes, they need never be imposed.
So far, that theory hasn’t gone very well in practice. Indeed, because the Bank of England let the inflation cat out of the bag, it is now having to clean up a right mess. This bit of the Telegraph article was worth a chuckle:
Gilt trip
Investors have fallen out of love with UK bonds this year. Hunt’s “dullness dividend” has not been enough to shake Britain’s so-called “moron premium”, a term applied in the markets after the mini-Budget.
Whereas in September the blame was laid at the feet of Truss and her chancellor Kwasi Kwarteng, now many are placing the dunce’s cap on the Old Lady of Threadneedle Street.
But let me remind you that the Bank of England led the interest rate charge. Even if it subsequently fell behind its American and Canadian peers. It’s just that monetary policy takes time.
And by the time it does hit, it’ll be much too tight, much too fast, again. I hope you won’t be surprised.
With mismanagement like this, who needs enemies?
Unfortunately, the ability of governments and central banks to impose their will on you via the financial system may be about to enter a new era. One where, in extreme circumstances, they could have absolute and complete control over your money, directly.
Which could mean even bigger mistakes, if their track record is anything to go by…
Find out what’s behind the upheaval, and how to protect yourself, here.
Until next time,
Nick Hubble
Editor, Fortune & Freedom
