Inflation in Britain will peak at 4

percent, the central bank predicts.

The Bank of England building, in the City of London. The House of Lords recently
asked the central bank to demonstrate that it has a plan to keep inflation under
control.

Credit...

Henry Nicholls/Reuters

By Eshe Nelson

Aug. 5, 2021
Inflation in Britain will rise to an annual rate of 4 percent later this year,
according to new projections by the Bank of England, a level that is double the
central bank’s target and one that hasn’t been reached in a decade.

But policymakers didn’t feel the need to immediately slow their efforts to
stimulate the economy. They said that the increase in prices would be
temporary and that inflation would return to its 2 percent target in 2023.

The central bankers also voted this week to keep interest rates at a record-low
0.1 percent and continue the bank’s enormous bond-buying program, which is
scheduled to run until the end of the year.

“The recovery will be bumpy given the nature and severity of the shock” to the
economy from the pandemic, Andrew Bailey, the central bank’s governor, said
on Thursday.
That said, the end of this emergency stimulus is in sight. Policymakers said that
if the economic recovery continued as they expected, “some modest tightening”
of monetary policy during the central bank’s forecast period, which runs until
early 2024, “is likely to be necessary,” according to the minutes of the policy
meeting published on Thursday.

Investors already expect interest rates to start rising next year.

The central bank also published updated forecasts for economic growth and
employment on Thursday. It said that the economy grew faster than expected in
the second quarter but that this would be offset by a loss of momentum in the
third quarter as the Delta variant of the coronavirus spread, dampening
consumer spending. Less demand

Overall, the economy will still grow 7.25 percent this year and recover to its
pre-pandemic levels, the bank said.

Inflation will be higher than expected, but the unemployment rate is forecast to
be lower. The central bank no longer predicts a jump in unemployment once the
government’s furlough program expires next month. Instead, the
unemployment will hardly budge from its current 4.8 percent.

Nonetheless, the shape of the labor market has been changed by the pandemic.
A quarter of a million more people are unemployed, about a million people are
still on furlough, and hundreds of thousands of people are now counted as
“inactive” because they have moved into full-time education.

All over the country, in a variety of sectors including hotels, restaurants, care
work and truck driving, there are reports of staff shortages. Job vacancies are
10 percent higher than before the pandemic.

“The challenge of avoiding a steep rise in unemployment has been replaced by

that of ensuring a flow of labor into jobs,” Mr. Bailey said. “This is a crucial
challenge.”

The central bank is betting that the disruptions to the labor market and supply
chains that are causing prices to rise will be temporary. Once the furlough
program ends, the bank expects some of the frictions in the jobs market to
dissipate. It also predicts that inflation in the prices of goods will decline as
more spending shifts back to services, such as hotels, restaurants and
commuting, as the longer pandemic restrictions are lifted.

The debate facing the Bank of England and other central banks, including the
Federal Reserve, is how much more stimulus the economy needs to ensure that
the recovery continues without overheating and losing control of inflation. In
Britain, the inflation rate is already 2.5 percent — above the bank’s 2 percent
target. Three months ago, the central bank predicted 2.5 percent would be the
peak reached at the end of the year. On Thursday, it significantly raised that
forecast to 4 percent.

Not every member of the bank’s Monetary Policy Committee is sure that the
above-target inflation will dissipate over time. Michael Sauders said last month
that he was not confident that “all the inflation overshoot will prove
temporary.” This week, he voted to end the bond-buying program early.

But he was overruled by the other seven members of the committee, and the
purchases will continue until the end of the year.

The central bank did issue an update on what it planned to do once it stopped
buying bonds. Previously, it has said it would raise interest rates to 1.5 percent
before it started selling the assets from the bond-buying program, a threshold
that has never been reached. On Thursday, the bank said it would instead begin
to reduce the stock of assets once it raised the interest rate to 0.5 percent by not
reinvesting the proceeds from bonds it already held that matured. After interest
rates reach 1 percent, the central bank would then consider selling off its stock
of bonds.
Part of the reason for lowering this threshold is that the central bank can now
enact negative interest rates. In February, it gave banks six months to prepare
for below-zero rates so it could make that policy change if needed. A negative
interest rate would mean charging banks to store cash at the central bank,
which would also lower the other interest rates in the economy, for example, on
loans to businesses and households. In theory, this would encourage more
borrowing and investment.

Since the banks were asked to prepare, the British economy has moved into an
upswing, albeit an uneven one, which has diminished the case for negative
interest rates. But now, the Bank of England would have this policy tool in its
pocket.

Eshe Nelson is a reporter in London, where she writes about companies, the British
economy and finance. @eshelouise

A version of this article appears in print on Aug. 6, 2021, Sectionntr B, Page 3 of the
New York edition with the headline: Bank of England Sees Britain’s Inflation Hitting
4% . Order Reprints | Today’s Paper | Subscribe
 The article examines a projected 4% annual inflation rate within the British economy, double

the central bank’s target. Drawbacks generated by the pandemic have caused the situation to worsen

as the Delta variant of the coronavirus has dampened consumer spending leading to a decrease in

consumer demand. However, policymakers speculate that inflation would return to its 2% target in

2023. If the economic recovery continues as expected, policymakers plan to implement an

expansionary monetary policy to stimulate the declining aggregate demand. Adjustments in the

central bank’s base rate can affect the level of AD in the economy. To increase aggregate demand, the

Bank of England has kept interest rates at a record-low 0.1%. This ultimately reduces the cost of

borrowing and will hence lead to increases in both consumption and investment.

Figure 1.1 Effects of Expansionary Monetary Policy

The effects of an expansionary monetary policy can be seen in figure 1.1, if the British

government follows a successful expansionary monetary policy then there will be a shift of aggregate

demand from AD1 to AD2. This will have a number of economic outcomes. There will be inflationary

pressure as the average price level rises from P1 to P2. However, there will be an increase in real

output, from Y1 to Y2 which leads to an increase in national income, an increase in economic growth,

and a decrease in unemployment. However, utilizing an expansionary monetary policy can increase
inflation rates over a gradual period of time. Hence, the central bank can also employ a contractionary

monetary policy to fight inflation by reducing the overall money supply by decreasing bond prices,

though in Britain’s case, the central bank has proposed to stop purchasing bonds. When imposed,

aggregate demand will decrease, causing a leftwards shift (indicating a decrease in demand). Since

interest rates rise, the cost of borrowing rises as well, resulting in lower consumption. Therefore,

when imposed, spending within the British economy decreases, prices decrease, and hence, inflation

rates slow down.

Moreover, updated forecasts by the Bank of England are indeed expecting the rate of

unemployment to be unaffected. The central bank predicts that once its furlough program expires next

month, the unemployment rate of 4.8% will hardly be affected. Despite the furlough program being in

effect, in which the British government advocates a temporary leave of employees while still

remaining to be paid, unemployment rates have remained stable. Hence, once the program is no

longer in effect, many more individuals are able to attend work causing a decrease in unemployment.

Nevertheless, the COVID-19 pandemic has generated detrimental effects on the labor market,

it has resulted in more than a quarter of a million people being unemployed and millions more had to

rely on the furlough program. The pandemic has caused Britain to undergo demand-deficient

unemployment (cyclical unemployment) in many of its sectors. This included hotels, restaurants, care

work, and truck driving. An estimated 10% of job vacancies have been recorded to increase, this is an

additional 10% increase as compared to before the COVID-19 pandemic occurred. The fall in

consumer spending was likely to lead to a fall in the demand for labor. As many firms cut back on

production, they will require fewer factors of production, labor being one of the crucial factors. As the

British economy moved into a period of slower growth due to the COVID-19 pandemic, aggregate

demand fell as consumers spend less on goods and services.

Demand deficient unemployment can also be associated with a decline in the business cycle.
 Figure 1.2 Demand deficient unemployment

In figure 1.2, the decline in aggregate demand from AD1 to AD2 causes national output (Real

GDP) to fall from Y1 to Y2. This had created widespread unemployment in the British economy

during the time of the pandemic, and therefore a fall in the general price level from PL1 to PL2.

Additionally, a deflationary gap can be implemented within the diagram. A deflationary gap occurs

when the economy operates below the full-employment equilibrium, the level of aggregate demand is

insufficient to create full employment. The deflationary gap is shown by the difference between the

full employment level of national output and the actual national output in the short run. Therefore, the

central bank’s decision to implement an expansionary monetary policy to raise aggregate demand

aims to restore full employment equilibrium at Yf (LRAS). Hence, closing the deflationary gap helps

to reduce cyclical unemployment in the economy.

The key concept present within this article is the concept of economic well-being. High rates

of inflation can affect the real income and purchasing power of many consumers in the long run.

Additionally, when it comes to individuals receiving fixed incomes, factors such as inflation can have

negative effects.