If it isn’t hurting, it isn’t working

“I understand the difficulties that many face with high interest and mortgage rates. But they – and the resulting slowing of the economy that we must see – are the means by which we will cure the problem. They are not the problem.

"The problem is inflation… Ending it cannot be painless. The harsh truth is that if the policy isn’t hurting, it isn’t working.”

– John Major, then Chancellor of the Exchequer, November 1989

UK inflation continues to surprise on the upside. In its Monetary Policy Report published in early May, the Bank of England (BoE) forecast that inflation would average 8.2% in the second quarter. Since then, we’ve had two prints of 8.7% for April and May. That 50 basis point (bps) overshoot relative to expectations has been met by a sharp increase in the market’s expectations for BoE policy this year.

Back in early May, expectations for the level of policy rates at the end of the year were around 4.75%. Today, they are close to 6.25%. Why has the market reacted so aggressively to that upside inflation surprise?

It’s the principle of the thing

Those with a bit of macroeconomics knowledge will have heard of the ‘Taylor rule’. That rule of thumb for central bank policy was first proposed by American economist John Taylor in 1992. In summary, it says that interest rates should be increased in response to either higher expected inflation or lower unemployment. A cottage industry has developed in the last couple of years in calculating different iterations of the rule and criticising/justifying central bank divergence from it.

The ‘Taylor principle’ is its lesser-known, but more interesting, sibling. That principle argues that nominal interest rates should be raised at least one-for-one with increases in inflation. Only by following that principle will real (i.e. inflation-adjusted) interest rates rise when policy is tightened. Every theoretical model of the macroeconomy embeds the assumption that the Taylor principle is a necessary and sufficient condition for stabilising inflation.

The reactions in the UK market since May are about three times the size we would expect applying the Taylor principle: 50bps on inflation has driven 150bps on interest rates. How should we think about that outsized reaction?

Better late than never

I think that the best way to understand it is to believe that the BoE was getting dangerously close to losing credibility. Forecasts were repeatedly found wanting and a growing gap between UK and overseas inflation meant that the market had begun to doubt whether the BoE had sufficient stomach for the anti-inflation fight.

The sharp inversion in the yield curve (i.e. short-dated yields rising much faster than long-dated yields) in the last two months suggests that has been won back with the recent policy pivot to faster hikes.

Although market expectations of where policy rates will be in a year’s time have shot up, there has been remarkably little movement in where the market thinks policy rates will be in 10 years’ time. There’s no hint of expectations of higher inflation in perpetuity becoming embedded. Instead, the market has become convinced that the BoE will, belatedly, do whatever it takes to solve the problem.

We’ve been convinced for a while that a recession was needed to create a sufficiently disinflationary impulse to bring balance back to the UK economy. The market has suddenly woken up to the fact that the BoE will have to tighten policy “until the pips squeak” to achieve that.

This shouldn’t be too big a surprise. As the Chancellor of the Exchequer laid out in the late 1980s, when it comes to inflation-fighting, “if it isn’t hurting, it isn’t working”.

Got a ticket for the pain train?

What does “hurting” mean in this context? First and foremost, monetary tightening will hit the interest-rate-sensitive parts of the economy: housing, commercial real estate, consumer durables. We think that is likely to drive up unemployment and tip the economy into recession.

The impact on UK equity and credit is diluted by the large proportion of revenues that typically accrues from overseas, but given that a stronger exchange rate is typically part of the ‘monetary policy transmission mechanism’ they are not immune.

It’s unlikely to be an easy environment for asset prices whose payoffs are tied to UK domestic growth prospects, but the alternative (i.e. allowing credibility in the monetary framework to be lost) is far worse.

In our view, the lesson from this episode is simple: central bank credibility is hard-earned, easily lost and costly to rebuild.