Twenty-five years since being granted operational independence, the Bank of England can look back at a successful track record. But with inflation once more resurgent, the Monetary Policy Committee faces the challenge of engineering a return to price stability without prompting a recession.
For those of us who follow UK monetary policy keenly, 6 May 1997 is a day that we shall never forget. The Bank of England won its long-sought prize, from the incoming (New) Labour government, of operational independence to pursue price stability.
Today, we mark the Silver Jubilee of that victory and look back at a successful track record. The UK’s annual rate of inflation – as measured by the Consumer Prices Index (CPI) – has averaged 2% from that date to this.
But with inflation now set to nudge double digits for the first time in over 30 years, the Bank’s Monetary Policy Committee (MPC) faces its sternest test as it seeks to engineer a return to price stability without prompting a sustained contraction in economic activity - a recession.
Why an independent central bank?
After the end of the Bretton Woods regime of fixed but adjustable exchange rates in 1971, the UK had long sought a credible nominal anchor for domestic prices – and failed.
From prices and incomes policies through monetary targeting to shadowing an external currency and then finally joining the exchange rate mechanism (ERM) of the European monetary system, it had not proved possible to adopt a workable nominal objective for domestic monetary policy to pursue.
Exit from the ERM in September 1992 led to the adoption of an inflation target the following month. But the choice of policy instrument for achieving the target was retained by the then Chancellor of the Exchequer, Ken Clarke. This meant that decisions on interest rate-setting remained subject to trade-offs against other economic and/or political judgements that would, over time, undermine the public good of price stability.
A growing body of evidence from economic research suggested that a rules-based policy pursued by a central bank with no other direct objectives, such as the need to get re-elected, would not only ensure more operational focus on the question of price stability but would also be credible in the eyes of firms and the public, who would then condition their own plans on that stated objective.
As long as there was a social consensus on the importance of price stability (which by the mid-1990s there was), it made sense to hand the month-to-month decisions on Bank rate to an independent committee of experts and officials. (Bank rate is the main policy instrument of the Bank of England as it is the rate at which it deals with commercial banks and, as such, influences the interest rates that banks pay or charge for transacting with them.)
The questions of detail to consider were: what should be the level of the inflation target? Should it be a band or a point? Should it be a symmetrical target, with equal concerns about inflation being too low as it being too high? And what form of ‘punishment’ should be introduced should the target be missed?
The answers to those questions were and still are: around 2%; a point; symmetrical; and an open letter to the Chancellor explaining the reason for the target being missed and when we can expect to return to target.
What is the structure of Bank decision-making on monetary policy?
The MPC was established with four ‘external’ experts and five ‘internal’ Bank officials. It was formalised under a new Bank of England Act of 1998.
The Bank was charged with producing its own publicly available economic forecasts with which to guide its judgement on policy decisions according to a published timetable. The minutes from the meetings would be published, along with the voting record of the MPC members.
Although under observation by a Treasury official, the MPC would be free to choose whatever level of policy instruments it thought fit at its meetings. Each meeting would be chaired by the Governor who would have a casting vote if required.
By and large the structure of the MPC has remained stable since 1997, which implies some large degree of success. The MPC’s credibility is generally felt to have been supported by the transparency of the process and the accountability of its members to the media and the public, but also to Parliament via regular evidence sessions.
Ultimately, MPC members are accountable to the Chancellor of the Exchequer who sets out, at least once every 12 months, ‘how price stability will be defined and the government’s economic policy objectives’. (I leave the story of how the Bank dealt with the global financial crisis of 2007-09 and extended its policy instruments to include quantitative easing, QE, and macro-prudential instruments to another time.)
What is causing the current inflation surge?
The current rise in inflation has its origins in the stoking of global demand by monetary authorities around the world to help stabilise economic activity during the Covid-19 lockdowns.
As we approached the end of restrictions on our day-to-day freedoms, we faced supply chain disruptions. In the case of the UK, these were amplified by Brexit, which acted to raise prices further. These have now been ratcheted up by surging prices in world food and energy markets, because of the Russian invasion of Ukraine.
In the language of economists, not only did the Phillips curve – which is the relationship between inflation and the balance of demand and supply – get steeper but it also shifted in. This meant that a given level of excess demand was more inflationary that it might otherwise have been.
To some commentators, the combination of booming demand and supply constraints is strongly reminiscent of the 1970s. But unlike then, because of the Bank of England’s operational independence, we have a monetary policy regime that is not only credible but also has a good track record. That may be critical in managing a disinflationary path without excessive output volatility – in other words, reducing inflation without a deep recession.
Indeed, in pursuing a flexible inflation targeting approach and in the face of sufficiently large shocks and/or considerable uncertainty, the MPC can choose to delay the horizon over which inflation is brought back to target. In other words, as long as the public believes the MPC will bring inflation back to 2%, it can decide how long it takes to do this.
Is it broke enough to fix?
The UK’s poor economic performance since the global financial crisis, which has involved low rates of real growth but also Bank rate stuck near to zero (or what economist call the zero lower bound or ZLB), has built up some momentum for the remit to be changed by many influential commentators.
Although I argue here that we should put a stop to this momentum for changing the MPC’s remit and refocus on the core question of price stability, it does not follow that nothing should change.
First, there is no convincing basis for raising the inflation target, as some have argued, as this is not consistent with price stability. Such a move would prolong the pain of rising prices for households on low incomes and may make our public debt burden unmanageable, as interest rates would rise accordingly.
Some have argued that an increase in the inflation target would help to prevent policy being constrained by the ZLB: it would raise the long-run level of the policy rate and then there would have to be an even larger economic shock for the ZLB to be hit and so constrain policy.
But inflation would be more difficult to control if it chugged away at 4-5% a year. What’s more, as our research has demonstrated, with the use of QE, guidance and some use of negative interest rates (abroad), there are sufficient levers available even when the policy rate hovers around zero.
Second, there does not seem to be a strong case for broadening the remit of the MPC to consider questions of aggregate or distributional wellbeing or climate change, as the Bank does not have the tools to affect real standards of living across the income distribution or across generations.
But worse still, any multiplication in the Bank’s objectives, whether real or apparent, will undermine the ability of the MPC to hit the target for which it has both credibility and the necessary instruments.
Let us be clear that questions about the income distribution, intergenerational justice and the challenge of climate change are for the Treasury not the Bank of England. In fact, the biggest danger facing the Bank is that it is being asked to make up for the deficiencies or failures in Treasury policy-making.
But where the MPC can do better is to recognise more clearly that we are now in uncharted territory for this regime. It is more of a risk than before that such high levels of inflation will turn out to be stubborn and feed through into a persistent overshoot with wages and prices feeding off each other rather than low and stable inflation expectations.
This is even more likely because we are starting from a level of real interest rates (nominal rates adjusted for inflation) that are at historically low levels and not in themselves consistent with price stability.
There is also a significant risk that the temporary inflation resulting from a large one-off change in food and energy prices may rebound and even turn into deflation (a general fall in the prices of goods and services) if rates were to overshoot and policy became too tight.
In this highly uncertain world, there is a need to be clearer not only about what might happen at the next MPC meeting but how Bank rate and the stock of QE might evolve over time under worst- and best-case scenarios for inflation.
In this, many would favour a move away from seeking consensus at MPC meetings to encouraging much more dissent: unusually for economists, perhaps there is simply too much agreement!
None of us know the future, so let each member be allowed to project their opinions, including on the path of Bank rate based on their own view of the economy, and be prepared to provide and be subject to much more expert scrutiny. We need to examine the different paths for policy interventions and assess alternatives.
Then we may have to choose or focus on the least-worst option. It is a much-abused phrase, but it is also very instructive: let’s get back to the basics – which for the Bank of England means producing and explaining policy alternatives to markets, the media and the public.
Where can I find out more?
- The Money Minders: The parables, trade-offs and lags of central banking – recently published Cambridge University Press book by Jagjit Chadha.
- Surging inflation shows no signs of slowing: Publication from the National Institute of Economic and Social Research (NIESR).
- Global inflationary pressures and the UK economy: NIESR publication focusing on the economic impact of the war in Ukraine, the UK labour market, and UK inflation.
- No respite for UK consumers and the Bank of England as inflation hits 7 per cent.
Who are experts on this question?
- Kate Barker
- Willem Buiter
- David Cobham
- Petra Geraats
- Charles Goodhart
- DeAnne Julius
- David Miles
- Stephen Millard
- Charles Nolan
- Andrew Scott
- Paul Tucker
- John Turner