How Andrew Bailey's missteps doomed Britain to high inflation lasting until 2023

Two weeks ago, Andrew Bailey was talking tough on price rises.

“Returning inflation to its 2pc target remains our absolute priority, no ifs, no buts,” the Governor of the Bank of England said as he raised interest rates from 1.25pc to 1.75pc in the biggest increase in borrowing costs for more than 25 years.

Unveiling Threadneedle Street’s latest forecasts, Mr Bailey said inflation would rise above 10pc later this year, before peaking at 13.3pc and then dropping back sharply in late 2023 and early 2024.

Little did he know it, but inflation was already accelerating faster than the Bank expected, rising into double figures last month.

It expected inflation of 9.9pc in July. Instead price rises broke into double figures, at 10.1pc. There are growing signs inflation could linger for longer than the Governor hopes, despite his fighting talk on higher rates.

Where did it all go so wrong?

The Bank’s recent track record on inflation is instructive. A year ago, policy setters thought inflation would peak at a mere 4pc - double its 2pc target, but well short of the 5.2pc peaks hit in 2008 and 2011.

At almost every opportunity since, it has been forced to upgrade its predictions in a long, painful game of catchup. It has still not caught up, as shown by the latest underestimation.

Thomas Pugh, economist at RSM, says this is in part due to the extreme volatility in global commodities markets, caused by the pandemic, subsequent economic recovery and then the war in Ukraine.

All of this has been “inherently unpredictable,” and the Bank relies on the forward curve in financial markets which has in many cases turned out to be an underestimate.

But that is not the only problem.

Given it is 40 years since inflation was last this high, “the economy has changed a huge amount” so there is “a large degree of uncertainty as to how businesses pass [rising costs through] to consumers,” says Mr Pugh. Simply put, it’s not clear that interest rate rises will be as effective at taming rising prices as they were in the past.

“There is no guarantee it will work the same way as it did in the 1990s or 1980s,” Mr Pugh says, given the wave of globalisation and the rise of the internet, which has reshaped the way businesses and the wider economy work.

Andrew Sentance, a former policymaker at the Bank of England, says Threadneedle Street has failed to appreciate a more fundamental risk of inflation taking off in the domestic economy underneath the global swings in prices and the fearsome jumps in energy bills.

“They are not really properly understanding the causes of the current inflation, and therefore continue being surprised it does not conform to their forecasts,” he says.

“They are still looking at this through the lens of a temporary blip. We are moving into possibly a more serious inflationary era which is going to need a tougher monetary response. They do not like that idea, it makes their job very uncomfortable.”

It would have been hard for the Bank to have stopped the current wave of inflation.

Ben Broadbent, a deputy governor, argues that even if officials had perfect foresight of the shock to come, they would have had to raise interest rates sharply in the pandemic and cause a far greater recession to stamp out price rises caused largely by global forces.

Regardless, the Bank must now work out how to stop inflation becoming embedded for the longer term.

This is a growing threat.

It is not only the volatile components of energy and food that are wreaking havoc on family finances. Stripping out these two culprits, which have been sent through the roof in part by Russia’s invasion of Ukraine, “core” inflation is also rising.

This can be thought of as something closer to domestically-generated inflation, showing that upward pressure on prices are developing on the home front as well as internationally.

“Core” inflation hit 6.2pc in July, its highest rate since 1992.

This rise is particularly concerning as it raises the prospect that inflation could stay high even once energy and food prices level off or - hopefully - start to fall.

This “core” inflation is the element most affected by Bank of England policy changes, so its rise indicates officials are under more pressure to increase interest rates.

Rising costs for energy and food are also not simply down to the war in Ukraine.

The pound has slumped almost 12pc against the dollar in the past year, which means buying goods from overseas - particularly those priced in the greenback, including most major commodities - is more expensive now than it was 12 months ago.

Wages are struggling to keep up with prices, but there are signs of pay rises picking up. In cash terms, regular weekly earnings in the private sector in the three months to June were up 5.4pc compared to the same period of 2021.

That is the fastest growth since last September, when numbers were distorted by furlough. Excluding the pandemic period, this is the fastest growth since records began in 2001.

While workers may cheer these rewards, they risk making the Bank of England’s inflation headache even worse.

“The big risk is that inflation becomes more embedded into the system,” says Mr Sentance. “You can see this in wage discussions at the moment. People are not discussing 2pc, 3pc or 4pc pay increases, they are discussing 6pc, 7pc, 8pc or even higher.”

Mr Bailey has called on well-paid workers not to push for big pay rises, and for businesses to show restraint in putting up prices, in the hope of bringing inflation back under control.

But July’s inflation data suggests wage restraint alone is not enough. Mr Bailey is likely to follow through on his fighting talk with more interest rate rises in the coming months.

“They have made it clear their priority is inflation,” says Pugh.

“By forecasting a recession and raising interest rates by 0.5 percentage points at the same time, that sends a clear signal that if a recession is what it takes to get inflation back under control, that is what they are prepared to do.”