Bank Can’t Just Blame COVID and War — It Has Mismanaged Demand

Such efforts went way too far, but many economists seem in denial about the consequences. Echoing Andrew Bailey, the Bank of England governor, the macroeconomist Simon Wren-Lewis has claimed that today’s inflation is overwhelmingly “about external shocks to the price of commodities, and supply problems that emerged because of the pandemic”. In other words, factors outside of policymakers’ control. If only that were so. Parsing the relative impacts of supply and demand shocks from price and output data is difficult. Generally, though, we’d expect a sharp oil price rise and supply chain woes to affect the composition of trend nominal (money) GDP growth if our Bank took demand control seriously, with higher prices the flip-side of weaker productivity growth.

This isn’t the full story. Last week’s data instead reaffirmed that nominal GDP grew rapidly this past year, surpassing its trend for the past decade in advance of Putin invading Ukraine, before accelerating to 3 per cent above it in the first quarter of 2022. Instead of keeping spending growth stable, the Bank buttressed supply induced inflation by overcooking aggregate demand, too.

This overshoot helps to explain the broad price rises we’ve seen. Despite being least affected by the “sequence of shocks” that Bailey deems “unprecedented”, the service price index is growing at an annualised rate of 5 per cent, rushing above its pre-crisis trend. Certain asset prices have shot up, too. As the monetarist Tim Congdon observes, astutely, “apocalyptic” rises in energy or food prices can hardly explain house prices in Cornwall and Pembrokeshire rising 50 per cent since the spring of 2020. Perhaps the money supply increasing by a quarter, creating too much money chasing too few assets, accounts better for that fact?

Yes, one must think carefully about the policy recommendations that flow from supply and demand shocks occurring simultaneously. The Bank could always whip the inflationary effects of rising commodity prices through tighter money and a stronger pound, but in doing so would compound a real output squeeze on the supply side with one on the demand side.

There’s a strong case, then, for the Bank’s monetary policy committee to ignore genuine “supply side inflation”, which should be temporary in any case. Where economists have erred is to wave away growing evidence of excess demand forcing up prices too, something the Bank should feel duty-bound to moderate unequivocally.

With the financial crisis aftermath fresh in their memory, though, many commentators seemingly oppose all demand restraint, with one insisting inflation be treated with “benign neglect”. The public do not buy it. The Bank’s recent inflation attitudes survey showed net dissatisfaction with its inflation handling for the first time, with inflation expectations elevated for years to come.

For two decades, oil price rises were all that punctuated the tranquillity of relatively stable price growth. This bred a complacency to always blame external forces. That inflation is elevated across the West undoubtedly highlights the effects of the pandemic and war. But that this has been much worse here than in, say, Switzerland or Japan, is evidence of a mismanaged demand response that Nadhim Zahawi, the new chancellor, should remind Bailey it is his job to confront.