Why I hope Liz Truss is lying

Liz Truss, the favourite in the race to succeed Boris Johnson as prime minister, has laid the blame for inflation at the door of the Bank of England, saying it must do more to fight price rises.

Truss also said she would change the Bank of England’s mandate if she becomes prime minister, to ensure that the central bank fights inflation more efficiently, but gave no details about what that change would entail.

With consumer price inflation hitting a 40-year high of 9.4% in June, you may think she has a point. The Bank of England is behind the curve, but when it comes to changing the central bank’s mandate, I really hope Liz Truss is lying. If she is not, then we should all be very afraid.

Truss has chosen to ignore completely the role of the government in fighting inflation (usually done by dampening demand with the help of higher taxation, which reduces discretionary spending), arguing that price rises are the result of a “huge” shock to supply, hit by the Covid pandemic and then Russia’s war on Ukraine.

She is right in saying that in times like these, when energy prices are going through the roof, pushing all other prices up, families fighting a cost-of-living crisis should ideally not have to deal with tax increases as well.

However, putting the responsibility of curbing inflation solely at the Bank of England’s door is disingenuous at best and, at worst, irresponsible. It could have catastrophic consequences on the UK economy.

The Bank of England has two main ways to curb price increases: raising interest rates, and reversing its policy of purchasing government debt from the markets, which was known as “quantitative easing”. Both these policies need to be calibrated very carefully; rushing either of them would tip the economy into a deep crisis.

Housing market danger

The housing market is very sensitive to any increase in interest rates, even though for the moment three quarter of mortgages are on fixed rate deals.

However, these typically expire after a few years and, if the Bank of England accelerates the pace or rate hikes (the most recent one was a half of a percentage point), some homeowners may find themselves unable to refinance and forced to sell.

This would push down house prices, potentially creating a snowball effect. With so much of the UK’s wealth tied to the residential property market, any substantial fall in house prices risks causing a deep recession.

What about selling down the government debt the Bank of England has purchased? This would curb inflation by also acting on interest rates, although indirectly: the sale of the government bonds would depress their prices and send their yields, which move inversely to prices, higher.

Government bond yields serve as a benchmark for interest rates on other loans, so this would mean rates of interest on loans taken out by companies, for example, would increase by the same, or higher, percentage. This would push up businesses’ debt burden, just when they need funds to invest and keep the economy going.

Government debt

Another victim of a more aggressive approach by the Bank of England would be the government itself. The central bank owns around a third of the UK debt, and dumping large quantities of bonds on the market would create a glut of sovereign debt.

That would happen just as the government would need to borrow even more to cover the shortfall of money created by Liz Truss’s promised tax cuts. The Treasury would struggle to find buyers for its debt, and would therefore have to pay higher interest rates to entice them.

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The higher interest rates would choke the economy further, pushing the housing market into an even deeper crisis, which would in turn hit demand even more. The central bank would want to avoid such a spiral of horror at all costs.

This may look like a very gloomy scenario, but in the current economic environment, it is entirely plausible. Surely Truss or her advisers have taken it, or a very similar one, under consideration.

Therefore, I hope Liz Truss is lying when she says the Bank of England should step up the fight against inflation. At this stage, the government and the central bank should work in tandem to try to keep inflation under control as much as possible, but all the while trying to shelter the economy.