MNI INTERVIEW 2: BOE Cut Too Fast As Wages Spiral - Chadha

The Bank of England Monetary Policy has cut its policy rate too rapidly at a time of inflation-fuelling public sector pay rises, former National Institute of Economic and Social Research director and Cambridge University professor Jagjit Chadha told MNI.

Structural supply side weaknesses and the government's inability to get through spending cuts or put a lid on public sector pay growth have meant that inflation has proven sticky rather than fleeting as some BOE officials had previously hoped as they reduced Bank Rate from 5.25% to 4.0% in 12 months, Chadha said in an interview. 

"I dread going back to the ... Team Temporary, Team Permanent debate. The best way to make inflation temporary is to treat it as permanent and act upon it," Chadha said.

"The fall from 5.25 to four, I think, has been a little bit too rapid, given the persistence of inflation, given where service sector inflation was and, importantly, given the rigidities in our supply side. Part of the story of our low productivity, low growth world is that any demand shock shows up very quickly as an inflation shock and is likely to be persistent," he said.

"it's not as though demand in this country then leads to further supply. We've got supply chain problems. We've got structural problems.”

The Monetary Policy Committee should have "remained a little bit more hawkish in this period, understanding that, historically, 5% is not high at all.”

REAL RATES NOT ELEVATED

With inflation running at 3 to 4%, it was 3.8% in July, the real rate now is only marginally positive and the BOE's own forecasts show inflation staying substantially above target, Chadha noted.

"If we're forecasting inflation at 3% for the next year and a half, it strikes me that's not a great place to be cutting rates from.”

While the UK is not in his view suffering, so far, from fiscal dominance, where the fiscal position is so vulnerable that the central bank does not feel it can raise interest rates to levels appropriate to control inflation, Chadha does see fiscal policy as part of the problem.

"I think financial markets are seeing a government that is not fully in charge of circumstances, could not get a cut in welfare benefits, despite having a huge majority, looks as though it doesn't quite have a plan or a path for fiscal policy inflation, and is getting worried about where that's going to be," Chadha said.

"Don't forget, they've agreed really high wage settlements for people in the trade union sector. And we know there's a relationship between settlements in the public sector and the private sector, and I think that is something that is at some level fuelling inflation, outside of the Bank's choices, that make it more persistent. It's ... creating that price wage spiral," he added.

QT RISKS

The BOE also has a decision to make this month on the next year of gilt sales as part of its quantitative tightening programme, with expectations it could cut back or even axe sales at the long-end of the curve with the 30 year yield hitting its highest level since 1998. (See MNI INTERVIEW:  BOE To Cut Long Gilt Sales - Ex-MPC's Saunders )

The move higher in UK 30-year yields, while not necessarily causal, is correlated with the start of the QT cycle, Chadha noted.

"The Bank's own view on QT was that if we sell into liquid markets, we won't change prices. Well, if we have changed prices, these are not liquid markets, and they're markets in which people have been reluctant to hold UK debt," he said.