Sunday, March 03, 2013
The Bank of England has lost its compass
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

When the Bank of England was made independent in 1997, I thought it was an excellent move. What better way was there to protect the economy from flaky politicians? The days of interest rate cuts timed for party conferences or to secure a pre-election political advantage would surely be over. Low inflation would be safe in the Bank’s hands.

Now, the boot is on the other foot. George Osborne, responding to the Moody’s downgrade, has shown a lack of flakiness so far, saying it strengthens his determination to cut the deficit. The Bank is another story. It has taken me longer than some but I am no longer so sure monetary policy is safe in its hands.

As most will have seen from the headlines, a few days ago Paul Tucker, one of the deputy governors, took the Bank into new territory by floating the idea of negative interest rates. “I hope we will think about whether there are constraints to setting negative interest rates,” he said in evidence to MPs on the Treasury committee. “This is an idea that I have raised.”

He was talking about the possibility of a negative rate on some of the £280bn of reserves commercial banks hold at the Bank, with a view to encouraging them instead to lend into the economy. He probably did not expect it to be reported as a new assault on savers.

The confusion was, however, justified. Bank rate is what the banks receive on their reserves. To pay them a negative rate without penalising everybody would require an entirely different system, which is one reason why Charlie Bean, Tucker’s fellow deputy, distanced himself from it the following day. He would need some convincing that such a policy would work to justify the shake-up it would require.

The confusion did not end there. Markets, encouraged by speeches by Sir Mervyn King, and the monetary policy committee’s (MPC’s) own minutes, had got used to the idea that quantitative easing, £375bn so far, was being paused while the Bank gave the £80bn Funding for Lending scheme time to work.

Now, the Bank appears back in full QE mode. It emerged 12 days ago that three of its members, including King, voted for a further £25 billion of QE. Tucker told MPs that “nobody on this committee thinks that QE has reached the end of the road”.

Paul Fisher, his colleague, the Bank’s executive director for markets, said in a speech he favoured a “prolonged run” of gilt purchases. He also said, curiously, the Bank was wary of distorting markets. Surely purchases of gilts equivalent to 25% of gross domestic product are distorting?

This outbreak of hyperactivity from senior Bank people does not seem to have been driven by any deterioration in the economy. The bottom line is that the Bank is prepared to relax policy further - nobody will be surprised by another £25bn of QE this Thursday - even as its forecasts (which are usually optimistic) show inflation above target for at least the next two years.

This has not gone unnoticed in markets. BNP Paribas says there is “total confusion” over the Bank’s use of its policy tools. J.P. Morgan says the Bank’s policy framework is “creaking” and that there is a “shambles” over the issue of when it will seek to bring inflation back to target.

These are not the only worries. The Bank, by tradition, refrained from comments on the pound. I recall, at an IMF meeting in Prague in autumn 2000, trying to get Eddie George, the previous governor, to say something about sterling, which was strong (1.70) against a sickly euro.

I thought it was a subtle question but Eddie saw straight through it. He didn’t quite say: “I didn’t get where I am by talking down the pound”, but it was close. The last thing the Bank wanted was to be associated with a sterling slide.

Times have changed. Short of erecting a sign on the front of the Bank saying “Sell Sterling”, it could barely do more than signal its desire for a lower pound. King has been a champion of sterling depreciation, if that is not a contradiction in terms.

When he introduced the Bank’s November inflation report he said it was hard to see anything other than a “slow and protracted recovery” in the absence of a fall in the real exchange rate. The pound duly obeyed, vying wih the yen as the weakest major currency of 2013. In its latest minutes, the MPC noted the “expansionary impetus” from the pound’s fall.

Martin Weale, a fellow MPC member, in the most explicit endorsement of a lower pound, said in a speech on February 16 it was the “most natural” way of resolving Britain’s balance of payments problem.

The trouble with this is that we have already had one of the the biggest sterling falls in history, the 25% drop in its average value in 2007-8, the effect of which has been to push up inflation through higher import prices while doing little for exports. There is no reason to believe a further fall would be any different in its effects.

The pound, clearly overvalued against the euro in 2000 when it was 1.70, is undervalued now at 1.16. It should not be falling against a euro whose problems go beyond the tendency of Italians to vote for clowns. For the Bank to try to push it down is wrong.

What can be said in the Bank’s defence? Its senior officials seem determined to show, before the summer arrival of Mark Carney, that they are capable of imaginative thinking on monetary policy, even if those ideas come to nothing.

There is something in this, though it represents a late flowering for what has always come over as a conservative institution. There is also a proper way to convey new ideas, not in impromptu answers to Treasury committee questions.

The Bank can also argue that the inflation it influences is under control. Average earnings are rising by 1.4%, while the gross domestic product (GDP) deflator, which measures economy-wide inflation, rose just 1.1% in the past 12 months.

These are not, however, the things the Bank is supposed to target. It has rarely hit the 2% inflation target in the past eight years and, on its own forecasts will not do so in the next 2-3 years. A decade of above-target inflation is, for any central bank, flaky. The Bank has lost its compass.