Bank of England

We didn’t see this coming because for 25 years we thought we had inflation licked

Published on 4 July 2022

'Pretty much everything we could have got wrong, we got wrong.' Paul Johnson on why economists failed to see inflation coming.

Why did no one see it coming? That’s what the Queen asked on a visit to the London School of Economics in November 2008.

Despite efforts by the Italian finance minister to claim that Pope Benedict XVI had foreseen the financial crash as far back as 1985, this was rather a good question and one we should be asking again.

Look back at official forecasts from a year ago, for the UK and every other advanced economy, and none were even close to forecasting our current predicament. All around the world, resurgent inflation came as a surprise to central bankers and other policymakers.

Just to lay one thing to rest: current levels of inflation are not largely down to the war in Ukraine. That is an easy get-out. It has made things worse — but prices were surging well before President Putin sent in his troops. Growth forecasts were already being slashed. Most of our problems would still be with us.

Cast your mind back a year or 18 months. The danger then appeared to be that unemployment would take off. That once furlough ended, lots of zombie jobs would disappear. I was worrying about what was happening to young people. They were bearing the brunt of furlough and an increase in unemployment.

Come the autumn and furlough’s end and not only did unemployment barely blip up but vacancy rates surged. Young people are back in work. The problem ever since has been too many jobs and too few people looking for them. I didn’t hear anyone in the early months of pandemic predict either that issue or the specific change we have actually seen: the large-scale exodus of older workers from the labour market.

Pretty much everything we could have got wrong, we got wrong. I include myself here. Concerned about unemployment and recession, we economists largely cheered on as the chancellor provided hundreds of billions of support to the economy. A few of us raised an eyebrow at the scale of monetary support. That the Bank of England, through expanding quantitative easing, happened to purchase almost the same amount of gilts as the additional amount issued by the Treasury began to look suspiciously like monetary financing. But a year ago, was anyone predicting 11 per cent inflation? No doubt there was someone crying in the wilderness, but if there was, they were not heard.

In the US, Larry Summers, the economist and Democrat who had been Treasury secretary under Bill Clinton and head of Barack Obama’s National Economic Council, was raising the alarm over the scale of Joe Biden’s stimulus package. In an interview in the Financial Times in April last year he warned that the excessive scale of the stimulus “could manifest itself ... in rising inflation and a ratcheting up of inflation expectations ... in the Federal Reserve feeling a need for a sharp and surprising increase in interest rates, and the subsequent deceleration of the economy into recession.” He was right.

Here in the UK, given the uncertainties over Covid and the need to avoid mass unemployment and immiseration, there was a good case for erring on the side of generosity. We erred too far. There were warning signs. Unemployment never rose by much. Saving rates went through the roof: a fact we need to remind ourselves of today. Many do have a cushion against the rise in the cost of living. Asset prices boomed. Supply chains were struggling. The provision of government-backed loans to businesses with few checks looked risky at the time. Furlough, with few questions asked, at 80 per cent of salary, was more generous than other countries. If the initial instinct to throw money at the problem was wholly understandable, the slowness to see the risk of incipient inflation feels less so. Even by last August the Bank was expecting inflation to peak at 4 per cent and be on its way down by now.

It’s all very well, with the benefit of a bucketful of hindsight, to make these points now but we need to learn two big lessons, lessons we should have learnt long ago.

The first is that economies are not stable, and just because they have been behaving in a particular way for a decade or more does not mean they will continue to do so. My goodness, we should have learnt that in 2008. In the run-up to the financial crisis economists and policymakers who should have known better were declaring the end of boom and bust, that macroeconomic policymaking had become so easy as to be boring.

For nearly 25 years until today, the era of independent central banks, we thought we had inflation licked. Since 2010 it has gradually become presumed that ultra-low interest rates will be with us for good, despite never having been so low before in the whole of history. There is at least the appearance of too much group think and too little challenge to prevailing orthodoxies within the Bank, the Treasury and international economic institutions.

Second, even if we give the Cassandras a voice, and listen to them, we really can’t predict the future. We just don’t know whether the next decade will turn out more like the 1970s, the 1990s or the 2010s. So, we need at least a little humility in our policymaking and a recognition of the scale of what is unknown.

Reflecting on some of these uncertainties, the Office for Budget Responsibility will bring out its fiscal risks report this week. It will focus on heightened geopolitical tensions, energy and the ageing population. The first two are risks that have already crystallised, which we didn’t see coming and for which we were ill prepared. The third is known, and we can, if we wish, prepare for it. It’s what we don’t see coming that causes the real problems.

This article was first published in The Times and is reproduced here with kind permission.