We may have been spared the ordeal of another mini-Budget on Halloween, but on Thursday – just two days before Guy Fawkes night – we should expect some fireworks from the Bank of England.
On the face of it, the economic and financial situation has been transformed in a matter of days. The pound has recovered and is even slightly above where it was before Mr. Kwarteng’s “special fiscal operation”, and the prices of government bonds are also higher (meaning that their yields are now lower).
Moreover, whereas the financial markets at one point expected Bank Rate to peak at over 6pc, they now think it is likely to top out below 5pc.
This has already brought some relief to the mortgage market, with offers available at well below recent panic levels.
Nevertheless, this doesn’t mean that the Bank of England can sit back and relax. Indeed, only last week the Prime Minister said that the Bank must take the leading role in getting on top of inflation. That is code for saying that interest rates have to rise, and possibly by a substantial amount.
One consequence of postponing the Chancellor’s fiscal statement from Halloween is that the Bank will not know the details of the Government’s fiscal plans when it makes its decision on interest rates this Thursday. As it happens, I doubt whether that will make much difference.
The Governor has been briefed about the coming fiscal statement and in any case, the direction of interest rates is crystal clear: they are going up. The only questions are how high the peak will be and how quickly we will reach it.
Although fiscal shenanigans and the vagaries of the financial markets have taken over headlines in the last few weeks, the underlying economic reality remains largely the same.
The economy seems to be heading towards a recession, if it isn’t already in one, and inflation remains uncomfortably high.
True, lower energy prices and the recent strengthening of the pound will help to contain inflationary pressures. But it still looks likely that inflation will rise from its current level of 10.1pc.
Most concerning is the fact that the growth of average earnings has picked up to 6pc. Moreover, with widespread anxiety about squeezed real incomes and a threat to living standards, there is every prospect that this rate will rise over the winter amid a flurry of strikes and economic disruption.
Admittedly, the headline rate of inflation should fall quite dramatically later on next year as sharp rises in energy costs fall out of the annual comparison. But that does not in any way guarantee that inflation will fall back to the 2pc target.
Indeed, if the growth rate of average earnings settles at 6pc, with productivity growth likely to run at 1pc at best and quite possibly next to zero, the underlying rate of inflation could easily get stuck at 5-6pc. Accordingly, the pressure is still on the Bank to raise interest rates.
Some economists believe that the Bank and its counterparts around the world are uniquely responsible for the current inflation surge, by keeping interest rates ultra-low and expanding the money supply by buying government debt.
It is true, in my view, that central banks persisted with this policy for too long. They should have moved towards tightening monetary policy earlier and proceeded to tighten more quickly. If they had done so, the upsurge in inflation would have been more modest.
Nevertheless, they wouldn’t have been able to stop it altogether. This inflation surge has real as well as monetary foundations - namely the supply disruptions following Covid, and more recently the surge in energy and food prices caused by Russia’s invasion of Ukraine.
Similarly, some economists (often the same ones) appear to believe that it is possible to allocate responsibility for reducing inflation solely to the central bank while allowing fiscal policy to deal with the overall level of demand in the economy.
That means, in present circumstances, stopping the economy from falling into recession.
This is completely off-beam. Both monetary policy and fiscal policy influence aggregate demand and therefore have a bearing on inflation.
In current circumstances, to the extent that fiscal policy is tighter, other things equal, this means that interest rates have to go up by less.
We don’t know how much the fiscal stance is going to be tightened by, but it is highly unlikely that any action by the Treasury will be enough on its own to bring inflation decisively lower. So monetary policy will have to be tightened too.
Is there a danger of overdoing it? Yes. But with interest rates still so low and inflation threatening to become entrenched at a high rate, the greater danger is that the authorities will under-do the tightening.
And if inflation surprises us by readily subsiding to the target, then monetary policy can be eased. In due course, if the public finances improve sufficiently, fiscal policy could also be eased a bit.
None of this means that rates have to rise this week. But if they don’t, it will be a profound shock to the financial markets. A few weeks ago it had been thought by many market operators that rates might go up by as much as 11.25pc this week, taking them to 3.25pc. Now, though, most market operators seem to be expecting a rise of 1pc at most, and more likely 0.75pc or even 0.5pc.
Whatever the Bank does on Thursday, this is unlikely to be the end of it. To really get on top of inflation, I suspect that the Bank will have to raise interest rates a good deal higher and to keep them there for a while, even as inflation subsides. My best guess is still that Bank Rate will peak at about 5pc.
Roger Bootle is chairman of Capital Economics
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