Bank of England officials will be watching developments in the race to replace Boris Johnson as Tory leader and prime minister with close attention.
In normal times, central banks are supposed to pay little attention to the political swings that keep politicians busy in the tearooms and bars of Westminster. These are not normal times. Inflation has reached 9.1% and Bank staff are under pressure to raise interest rates to squeeze the economy and with it inflationary pressures that are pushing prices higher.
Ahead of last week’s political drama, Johnson and his former Chancellor Rishi Sunak were due to hold a press conference this week explaining how the government’s tax and spending policies would evolve over the next six months.
In his resignation speech on Tuesday night, Sunak said he was unable to agree a way forward with Johnson, who wanted to announce bigger spending on defense and welfare. Sunak couldn’t sustain this if it wasn’t funded by tax hikes. It is understood Johnson wanted to marry his extra spending with tax cuts, increasing the amount of money that would be pumped into the economy.
Sunak argued with No. 10 that the economy right now is a zero-sum game. Any increase in spending would be seen by the Bank as inflationary, prompting Threadneedle Street to raise borrowing costs even more than expected.
Now that same debate will play out, not between enemies at 10 and 11 Downing Street, but between rival candidates in an election campaign to succeed Johnson.
Last week, the Bank’s chief economist, Huw Pill, said a change in policy meant it had dropped its adherence to a “new tightening” policy, under which the Bank would raise the cost borrowing by small and regular increases, in favor of a more flexible policy which could lead to larger jumps in interest rates. “Acting to achieve the [monetary policy committee’s] The 2% inflation target is now more important than ever,” he said. “The MPC is committed to bringing inflation back to target in a sustainable manner over the medium term. In the first place, this required – and still requires – tighter monetary policy.”
Pill said he fears the UK economy could slow down and suffer a contraction – a development that would persuade him to suspend or even cut rates. “But it also requires that the tightening be measured and proportionate, calibrated appropriately to the current economic situation,” he added.
It is possible that when the annual energy price cap rises another £800 in October to around £2,800 inflation will have exceeded 11% and the cost of living crisis will have worsened.
However, other factors are at play, including the government, under its new leader, suddenly pumping billions into the economy via tax cuts and social spending. Giving people extra purchasing power would cause prices to rise when the supply of goods and services is limited by a shortage of workers and hard-to-obtain imports.
Pill declined to comment on the prospect of changes to government spending policy during a question-and-answer session at the World Banking and Finance Conference at King’s College London last week, but his defense of a Greater flexibility in the Bank’s response indicates that he and his colleagues will be watching Westminster closely.
Catherine Mann, Pill’s colleague on the Bank’s monetary policy committee, is already looking forward to a faster 1.25% base rate hike toward what many City economists think it could be. 3% by the end of next year.
Mann worries about a 12% fall in the value of the pound since January, with much of its fall blamed on the UK’s lackluster recovery from the pandemic. She attributes much of the rise in inflation to higher import costs stemming from a weaker currency.
But without a cohesive and far-reaching plan from a new Tory leader that investors can agree will build a sustainable path to growth, the pound could fall further, putting even more pressure on the central bank to it raises its rates.