The problem:

1. How does the Bank of England believe it can affect inflation?

2. What are the flaws in that belief?

How the Bank of England thinks it can affect inflation

One half of the charge with which the Bank of England has been saddled is the maintenance of
monetary stability. This is defined as price stability in theory and a 2% per annum inflation
target in practice. The question then is: How does it think it can achieve this target?

To answer this question, we must first consider their theory of inflation. At its simplest, they
posit that inflation is a function of a) inflation expectations and b) the output gap. The output
gap is the difference between actual and potential output, each often presented in growth
terms and the difference between them as a fraction of the latter. The Bank thinks it can sway
inflation expectations through, in essence, good publicity matched with a reasonable track
record. It does not believe it holds much sway over the economy’s supply capacity. But – and
this is most important – it believes it can affect actual output growth through its power over
total spending in the economy.

What must be explained then is a) how does it believe it can affect total spending and b) is that
belief justified by efficacy in practice?

The fulcrum of modern monetary policy is control over the Bank Rate. The Bank Rate is the
interest the Bank pays on its non-borrowed reserve liabilities. What is the theory that
ultimately connects variations in this Bank Rate to variations in total spending?

In practice, the Bank Rate has acted as a floor to money-market rates. In the event of a rise in
the Bank Rate, banks can essentially borrow cheap from the money-markets and deposit dear
at the Bank of England until money market rates rise to eliminate any prospect of further
profit. Money market rates in turn are seen to bear a direct relation with deposit and lending
rates, as well as yields on riskier assets. If deposit rates rise, agents are encouraged to
substitute saving with spending. If lending rates rise, there will be a decline in credit-financed
spending and investment. If short-term rates rise relative to long-term rates, there will be less
investment in longer-term riskier assets. Taken together, there will be a diminishment in total
spending.

The flaws in the Bank’s thinking

Evidently, interest rates are key – in theory. In fact, the relation between interest rates and
total spending in the economy is incredibly tenuous given the enormous attention paid to it.

It is well known by now that interest rates can be near zero or negative with negligible effects
on total spending. It is also well known that interest rates rise during periods of elevated
economic activity, both in periods of rapid output growth and rapid inflation. The notion that
low or high interest rates on their own can be construed as “loose” or “tight” monetary policy
is simply another instance of defining things by intentions rather than outcomes.

The issue is that total spending is largely a function of agents’ attempts to reach monetary
equilibrium. That is not to say that agents calibrate with mathematical precision that ratio of
nominal money to nominal spending/assets they desire, but that there do exist points at which
agents will feel that they have too much or too little in the way of deposits and currency.
Relative changes in this desired ratio have displayed a clear upward trend (or relative changes
in velocity, a clear downward trend) in the long-term and a tendency towards mean reversion
in the mid-term.

What this all implies is: what matters most to total spending is changes in the quantity of
money the public holds relative to their demand for it. Recent policy as of time of writing
(05/09/2022) is a case in point. The monetary overhang from the Bank’s quantitative easing
remains in spite of rate hikes. Which will win out – the monetary overhang or the rate hikes? If
inflation persists, it will have been the former. Excess money growth baked inflation into the
cake, and rate hikes can do little to extract it.

What can affect total spending in the opposite direction is quantitative tightening – the
extraction of the monetary surplus initially injected.