The Bank of England clearly still doesn't believe inflation is here to stay

Andrew Bailey, governor of the Bank of England

Markets weren't expecting Andrew Bailey to raise rates given the spread of Omicron.

(Image credit: © Chris Ratcliffe/Bloomberg via Getty Images)

published 17 December 2021

It appears that new Bank of England boss Andrew Bailey is a bit of a card.

In November, he pranked markets by deciding not to raise interest rates when he'd done everything bar wearing a t-shirt saying "rate rise incoming" to persuade investors that rates were about to go up.

Yesterday, he pranked them again by deciding to go ahead with a rate rise despite the economy going into pseudo-lockdown all over again due to pitiful government communication and hysterical headlining.

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What a japester!

But what does Bailey's merry tomfoolery mean for your money?

This is a gesture, not a fightback against inflation

The Bank of England raised the UK's key interest rate to 0.25% yesterday. That was up from 0.1%, which was the lowest level in recorded history.

And when I say recorded history, by the way, that's a lot of history. The Bank of England itself goes back to 1694. But if you want to go global, we've got records dating back about 5,000 years (the Babylonians invented bureaucracy) and so we know we're talking thousands of years here.

OK, so rates went up. What does it all mean?

That's a good question. Is 0.25% going to make a huge difference to the housing market? Probably not, unless it heralds many more such moves. And that's not clear yet.

Is it ramping up borrowing costs, to choke off the booming economy? Not really. Omicron is likely to cause problems – certainly in the hospitality sector – so the idea that the Bank wants businesses to crimp any expansion plans they have is clearly not correct.

So is it a gesture? That makes the most sense. At the end of the day, the Bank is meant to be charged with keeping an eye on inflation. It can't just sit on its hands when inflation is more than two-and-a-half times as high as the official target rate. So, yes – it's a gesture.

What does that imply? Well, it implies that whatever else the Bank says, it's basically hoping the same thing that the Federal Reserve and most other central banks hope. That inflation is transitory – as in "caused by factors that will naturally go away once the economy is less snarled up due to Covid".

How do we know it's a gesture? Well, let's just take a simple historic example to get an idea of what happens when you really are in an economy which has been in an inflationary environment.

Today, inflation as measured by both the consumer price index and the retail price index, is roughly at its highest since 1991 (the consumer price index briefly hit current levels in September 2008, but that was a one-off).

Obviously, the world is different today. We are – possibly – coming out of a long era of disinflation. Most people think that deflation is the enemy and the biggest threat.

In the early 1990s, we were at the tail-end of a long period of inflation and moving into this disinflationary period. At that point, inflation was still the big economic enemy and today's central banking regime is still based in that psychology to a great extent.

Anyway, so before I give you the big reveal, take a guess – no Googling – at what the lowest level of base rate was in the UK in 1991.

Today, it's 0.25%. What was it back then, when inflation was kicking around the same level as it is today?

Had a guess? OK, I'll tell you.

No cheating – take a guess first

In 1991, the UK base rate hit its low for the year in September.

At that point, it was 10.375%.

Fancy your chances of paying down your mortgage at that level?

And that was the low. At the start of the year, interest rates were sitting at 13.375%.

What's my point here? I'm not trying to scare anyone. It's not that interest rates will go back up to 10% – the country itself would be insolvent, never mind the individuals and businesses within it.

It's more to challenge this idea that the economy is a highly-responsive machine and the Bank of England is like an F1 mechanic. You see the engine starting to overheat a bit? Just give a gentle little tweak on the interest rate pedal and that'll sort it out.

This simply isn't how it works. The vast contrast between today's environment and the environment of the early 1990s should make that obvious.

Meanwhile, at the other end of the spectrum, the Wizard of Oz analogy – whereby a central banker is essentially powerless but relies on massaging confidence levels in the economy – isn't actually much good either.

Being aware of and sometimes manipulating market expectations is one tool in the central banking box, but they do have real and significant powers too, and markets are keenly aware of that.

A central bank can prevent the financial system from going bust (as it did in 2008) by acting as the lender of last resort. And it can knock the economy into recession if things are really getting out of hand on the inflation front (which is what Paul Volcker did in the early 1980s).

It's true that if a central bank - or in reality, a government – abuses those powers too much (eg by nakedly printing loads of money for no other reason than to fund government spending) then confidence will collapse and you'll get hyperinflation (which is what Turkey is now dangerously flirting with).

So these powers do rely on faith that they won't be misused. But that is something you can say for pretty much any institution, and it doesn't stop us from relying on them. (This is also why the hurdle for independent cryptocurrencies to replace fiat ones is much higher than many accept).

However, getting back to my main point. A central bank is a blunt instrument. The Bank of England and its fellow central banks hope that they won't have to wield those blunt instruments because they hope that inflation will get back in its box as soon as Covid does.

If you don't believe that's the case, and you think that we've moved into a more inflationary environment again, then you should be inflation-proofing your portfolio, because in the first instance, it will gradually become clear that inflation is here to stay and that central banks aren't acting to contain it.

A while after that, we'll reach the point where inflation is a genuine political liability – as opposed to the mid-term elections talking point which it currently is in the US – and central banks will have to get the hammers out. That probably means a recession. But we're a while away from that still.

So hedge yourself. And subscribe to MoneyWeek magazine as clearly this will be a big story all over again for 2022.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.