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Should Monetary Policy Be Used To Control Rising Prices Post-Pandemic?

As we continue progressing back to normality in a post-pandemic world, the additional demand which has built up over successive global lockdowns is slyly forcing prices upwards, contributing to inflation of 3.1% in the last year. With forecasts suggesting this could rise to 4% in the next few months due to squeezing of supply across multiple industries, not just national ones, is the Bank of England toolbox needed to reduce the inflation rate over the coming period?

Despite a rise in the unemployment rate during the pandemic as firms were forced to lay off workers, the hefty government stimulus package and relative stability of higher paid jobs has meant the emergence into freedom has been powered by a torrent of pent up demand. Spending by consumers skyrocketed, placing waves of pressure on suppliers to match the orders. Naturally, this squeezed producers as they were unable to cope with this rapid increase in demand, causing them to raise prices. This translated to inflation of 3-5% across the globe, depending on how much the rise in energy prices has pushed up overall inflation.

The rise in demand for energy from households and firms has severely impacted suppliers, causing prices to surge; for example, EU energy prices jumped by 17.4% with total inflation at 3.4%, while US energy costs rose by 24.8%, pushing average prices up by 5.4%. This stands to increase if supply cannot match the higher demand levels; stability is needed, as higher energy costs for firms will be passed onto consumers in turn.

There have also been shortages in the supply of capital goods, such as building materials and components used in technology, as demand for those types of goods has risen. Additionally, the UK has seen labour shortages in certain industries, in particular for lorry drivers, staff in bars, restaurants and hotels, and supermarket workers, which has in part been exacerbated by Brexit regulations, but also due to low wages not incentivising workers to return to their jobs. This has pushed up prices as firms must raise their wages to attract employees.

The potential impacts of this rising inflation could be highly undesirable for policymakers and the economy. The target rate of inflation set by the Bank of England is 2%, so anything above that is considered too high; if wages do not rise in line with current inflation, there is a fall in real wages, making goods relatively more expensive and reducing people’s spending power. If energy costs are also rising at catastrophic rates, they will take up a large portion of household incomes, reducing the ability to spend on other things and lowering living standards. There is a risk that if inflation persists, people will include their expectations in wage demands, contributing to an upwards price spiral as firms’ costs would also rise. The lack of certainty and stability on this point also leads to lower confidence for consumers and firms, as financial planning becomes riskier.

The governor of the Bank of England, Andrew Bailey, has most recently announced that the central bank is looking to use monetary policy to control inflation in the medium term, which means a rise in interest rates to reduce demand has been forecast. However, the labour shortages as a cause of inflation suggest monetary policy may not be needed, as interest rates are most effective when combatting an overheating economy where unemployment is low and wages are pushed upwards. Here, wages are rising to encourage people to work; government controls of fiscal policy and benefits can similarly incentivise the return to jobs.

The rise in energy prices could also be temporary; central banks usually choose to disregard inflation caused by fluctuating supply, expecting prices to stabilise. Past circumstances similar to this suggest the economy would be better off remaining cautious. The lack of real time economic data on employment and spending patterns means action should not be so rapid; it takes time for useful data to be compiled, while interest rates are said to take up to 18 months to have a visible impact on the economy. Technological advancements in macroeconomic planning could see a fundamental change in the approach taken by central banks in the future.

Nevertheless, the words from the governor were intentionally vague to try not to promise anything, although investors and traders are anticipating action from the central bank by the end of the year. This may in fact cause inflation to fall naturally, as markets act prior to the policy change. The bank might face a time consistency problem, whereby they could achieve a better macroeconomic outcome by doing nothing and allowing the market to adjust, incorporating expected rate rises, based on their announcements.

This could create a credibility issue, as the bank has an incentive to deviate from their initial policy statement, while market actors may come to expect these commitment instabilities in the future. Past cases have shown that the central bank should always stick to the policy it says it will implement to avoid trust issues developing. A market which does not trust the central bank can become extremely unstable, potentially rendering monetary policy much less useful at controlling the macroeconomy. However, the bank only said it would look to increase rates in the medium term, not in the next few months. The element of confusion may provide cover for the bank to ultimately do nothing and not face the consequences of a credibility crisis.

With those on the lowest incomes looking to see the worst impacts from higher inflation, the response to the current dilemma must be measured with regard to past incidents similar to this. In cases such as after the Brexit referendum when the pound fell, imports became more expensive and inflation rose, the bank allowed prices to stabilise and did not adjust their policy rate. If prices are expected to plateau, there may be no need to do anything, and the market may react on its own to find equilibrium. The last thing the central bank wants to do is cause an unnecessary economic slump by raising interest rates prematurely.

If price rises do persist well into the new year, it may be appropriate to introduce a tightening of monetary policy; right now, the bank should hold back to observe the market. However, it certainly is not too soon to show intent to combat the energy crisis by investing more heavily into green energy, loosening the supply constraints felt across the globe. A comprehensive commitment to this aim would not only help to solve supply shortages in short run crises, but would of course accelerate our progress towards a net zero future.