If it raises interest rates at the snail’s pace that the markets currently expect, reaching 1pc by December, then real interest rates would still be significantly negative, which would be a major factor boosting aggregate demand and thereby hindering inflation from falling back.
To get on top of inflation, central banks have traditionally had to push real interest rates into positive territory. If anything like that happened this year, it would have a major impact on asset markets.
That should not deter the Bank. We have been living through a substantial asset price boom, closely related to the laxity of monetary policy. Things cannot carry on like this.
The Bank will not want to spook the markets, but inflation may not co-operate with its desired softly, softly approach.
If it moves higher than the Bank expects and/or threatens to become stubbornly entrenched, then the Bank would have to jack rates up to levels that few in the markets have begun to contemplate. That would have a jarring effect on investors.
Actually, something similar may happen even if inflation does not misbehave.
If the economic recovery is strong and the labour market tight, then the Bank would be right to raise interest rates to head off a later resurgence of inflation. Only the combination of a soft economy and low inflation could upset the case for decidedly higher interest rates.
Similar considerations apply to the other arm of monetary policy, namely quantitative easing. It is high time for the Bank to reverse QE by selling some of its bonds. As and when this happens, it will sorely test the gilt market’s current insouciance. The ramifications of much higher gilt yields would be felt in all assets.
Inflation and the monetary policy response may be the dominating economic influences this year but over the last two years, economic performance has been driven by a non-economic factor – namely Covid. Other unexpected twists could throw a spanner in the works this year too.
In international affairs, there is a dangerous situation as Russia masses troops on the border with Ukraine. Meanwhile, China continues its sabre-rattling over Taiwan and Iran makes further progress towards developing a nuclear weapon.
In the purely political realm, April’s French Presidential election could be a game-changer. Not if the current incumbent wins, of course, but if one of the right-wing candidates prevails, there could be seismic implications for EU politics with potentially major economic consequences.
Here at home, the dominant political risk concerns the position of Boris Johnson. There is now a significant chance that before too long he will be unseated as Prime Minister. Most Conservative backbenchers are yearning to rescind planned tax rises and, indeed, to introduce some tax cuts.
In the medium-term that would probably be self-financing. But if the borrowing numbers are to be controlled in the near future, such a policy switch would have to be accompanied by tighter control of
government spending. Will that be the coming big shock of the year?
With inflation rising, interest rates moving up, government spending squeezed and the prospect of some taxes being cut, this year could seem like a return to the good old days. But were they so good? I rather fancy that different readers will have a very different take on that. Happy New Year to you all!
Roger Bootle is chairman of Capital Economics. You can contact him at roger.bootle@capitaleconomics.com
