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16 June 2022

Is recession the Bank of England’s only choice?

UK and US central banks are faced with a dilemma: allow inflation to keep rising, or hike interest rates to bring it down – at the cost of serious economic pain.

By Emma Haslett

With inflation still climbing, today the Bank of England has brought out the big guns, raising interest rates by 0.25 percentage points to 1.25 per cent – pushing the cost of borrowing to its highest since February 2009. It joins the US Federal Reserve, its cousin across the Atlantic, which yesterday raised rates by 0.75 percentage points – its biggest rise in almost 30 years.

Such rises will have a significant effect on the economies of the US and the UK. Central bankers are about to find out what life was like for Paul Volcker, who was appointed chair of the US central bank in 1979 and swiftly became known as the “most hated man in America” for his determined approach to tackling inflation.

In October 1979, price rises had climbed above 12 per cent when Volcker, who had been appointed two months previously, called a surprise press conference. As members of the media trailed in, Joseph Coyne, the Fed’s spokesperson, apologised for “bring[ing] you out on such a beautiful day”, while Volcker himself joked that “the major purpose of this press conference is to show that I have not resigned – the way the early rumour had it yesterday – and I’m still alive – contrary to the latest rumour”.

Then he got down to business. The US economy was a mess: inflation was in double digits, its highest level in half a decade, and economists were expecting it to rise further. The dollar was sliding and trust in the Fed was at an all-time low. Investors were piling out of traditional “paper” assets such as stocks and bonds, and buying up “precious metals, oil, copper, jojoba beans – any commodity, as long as it wasn’t paper”, according to the American financial journalist Roger Lowenstein.

Confidence in the US economy had been diminished by a string of Fed chairs who, even in the face of rising inflation, had sought to maintain a strong supply of cheap money, and presidents who had used that cheap money to fund wars while directing their Fed chiefs to avoid high interest rates at all costs. Something had to be done.

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Volcker outlined his plan: raise interest rates aggressively, and as often as was necessary, until inflation began to slow and the supply of money began to dwindle. And that is what he did, relentlessly. Just over 18 months later, the Fed funds rate had climbed to 19 per cent, and unemployment climbed, politicians threatened to impeach Volcker, while “Wanted” posters accused him of “killing” small businesses. Ultimately, his grand plan triggered not one, but two recessions. But Volcker, infamously, refused to back down.

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Paul A. Volcker, Chairman of Federal Reserve System. Photo by Bettmann/Getty Images

Today, central bank officials on both sides of the Atlantic find themselves faced with a similar dilemma: allow inflation to keep rising, or hike rates to bring it down, causing serious economic pain in the process. In the UK, inflation is at 9 per cent, four and half times the Bank of England’s 2 per cent target, while in the US it is 8.5 per cent; meanwhile, years of quantitative easing and rock-bottom interest rates mean borrowing is plentiful and cheap, and credit is ballooning. A rate rise is going to hurt, and like most painful economic shocks, it is likely to hurt the poorest the most – the people who, in the face of a cost-of-living crisis, are increasingly dependent on borrowing.

Volcker didn’t really have a choice, and neither do today’s central bankers. The only difference between Volcker and his predecessors was the courage of his convictions. “During the 1960s and early 1970s, various Fed chairmen made rumblings about fighting inflation, but they always backed down when the complaints about the resulting higher cost of credit grew loud,” wrote William Poole, the president of the St Louis Fed, in 2005 (before the Ukraine war, before the pandemic, before this bout of inflation – before, even, the previous financial crisis).

Hiking interest rates will increase the cost of borrowing, reduce the amount of spending in the economy, and very probably tip the UK into recession – the Bank of England governor Andrew Bailey, who has already faced several grillings from MPs about his failure to anticipate rising inflation, is in the uncomfortable position of being branded the man who put us there. But as Adam Posen, a former member of the Bank’s rate-setting monetary policy committee (MPC), pointed out last month: Bailey and his MPC are “duty-bound” to act. “The central bank has no choice but to cause a recession when a broad range of prices are rising at such a strong pace,” he said in May. To dust off that old meme: the Bank of England has one job.

The good news for Bailey is that after Volcker’s death in 2019, he was lauded for the relentless commitment he showed to that one job. “His accomplishment was monumental,” wrote the Washington Post in its obituary of him. “No one born after Volcker took office has ever experienced serious inflation.” Bailey and his contemporaries could be unpopular for years, but if they can stay the course, we may thank them in the end.

This piece was first published in the Crash, the New Statesman’s regular update on the global economy and the challenges it now faces. Click here to sign up.

[See also: Hillary Clinton interview: “I don’t think the media is doing its job”]