Sunday, April 10, 2022
A very unhappy anniversary for the Bank of England
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on www.thetimes.co.uk This is an excerpt. Not to be reproduced without permission.

Timing can be very cruel. In just over three weeks the Bank of England will be celebrating the silver anniversary of independence; 25 years in which it has been responsible for the setting of interest rates and other aspects of monetary policy. I can remember as if it were yesterday, within days of his becoming chancellor, the press conference at which Gordon Brown made his bombshell announcement.

Had this anniversary happened a year ago, it would indeed have been a cause for celebration. Inflation this time last year was a touch below the official 2 per cent target and, in May 2021, was almost exactly on it, at 2.1 per cert. The Bank’s actions during the pandemic had helped steer the economy through a period of disruption and uncertainty and, in the spring of last year, the economy was growing robustly, without a care in the world.

Things look rather different now. The country is gripped by a cost-of-living crisis and businesses are reeling under the impact of sharply rising costs. The Bank itself expects inflation to hit 8 per cent very soon and warned last month that it could be even higher by the end of the years. It may nudge 10 per cent.

This makes it the worst kind of anniversary, one of badly missed targets and an inflation cat that is not only out of the bag but is cocking a snook at the Old Lady of Threadneedle Street. This, though uncomfortable for everybody, may be no bad thing. It means that questions can be asked, rather nodding through the current monetary policy framework as an unalloyed success.

One thing should be said at the outset. There should be no return to the days when chancellors set interest rates, often for political reasons. While the Bank’s mandate was clumsily drafted – no central bank could be expected to exactly hit its target “at all times” – the 25-year inflation record has been a good one. Even including the current surge, inflation has averaged exactly 2 per cent over the past 25 years.

Independence also broke the British pattern of panicky interest rate hikes, usually in response to a falling pound. Official interest rates have been low, perhaps too low for some, averaging just 2.6 per cent over the past 25 years, compared with 10.4 per cent over the previous quarter-century. That was not all as a result of independence, but it was a big factor.

Independence was not all about monetary policy. The Bank lost its role in supervising the banking and financial system in 1997, and almost lost its governor, the late Sir Eddie George, in protest over the manner in which it was done. It got it back after the financial crisis and the system has been robust, through Brexit and the pandemic, since.

I cannot, however, ignore the elephant in the room, the fact that in this anniversary year inflation will peak at several times the official 2 per cent target. Some think the target to be changed, say to 4 per cent, while others think that there should be a different target, perhaps for the price level rather than the rate of change of prices, or for money GDP (gross domestic product), the combination of growth and inflation.

None of these, it seems to me, would offer a better policy guide. An inflation target, set at 2 per cent, an inflation rate which does not distort economic decisions, is the least bad choice. When the UK first adopted an inflation target, in the aftermath of the ERM (exchange rate mechanism) debacle of September 1992, some questioned its economic legitimacy. Could you really target something that was at the end of a process, rather than at the beginning?

To do so, the Bank required good and accurate inflation forecasting, something that has deserted it recently. In November 2020, which is when it might have been acting to head off inflation given the lags in monetary policy, the Bank’s forecast was that inflation in the second quarter of 2022, in other words now, would be below 2 per cent even if Bank Rate stayed at 0.1 per cent. That is why the Bank spent much of the pandemic adding negative interest rates to its “toolkit”.

Had the Bank known what was going to happen to inflation, perhaps it would not have responded, deciding instead to “look through” a period of high inflation rather than raise interest rates during the pandemic. This, indeed, is the get-out clause which can mean that hitting the inflation target is something of a fair-weather friend. In extreme circumstances, or when high inflation is due to an external shock, the Bank is allowed the leeway of not acting, when to try to bring inflation back to target would be at a prohibitive economic cost.

That is fair enough, but there is nevertheless room to criticise its recent actions. From about this time last year, when it was clear that there was gong to be a significant post-pandemic inflation problem, the Bank could and should have halted its quantitative easing (QE) programme, as many of us argued. But it carried on, easing monetary policy while inflation was rising, until the end of last year.

That was symptomatic of a wider problem for the Bank and its MPC, one of inertia. It continued with eh QE programme because it had announced that it would do so at the end of 2020. Operated flexibly, a sensible policy would have been to halt it.

That lack of flexibility can also be seen on interest rates. In the first half of its 25 years of independence, the MPC operated a “little and often” policy on rates, changing them 45 times in 12½ years, on average nearly four times a year. In the second phase of independence, lasting until now, the official rate has been changed just eight times, and that includes hikes in each of its last three meetings. It is almost as if the Bank came to regard interest rates as a dangerous weapon, one to be used infrequently if at all. But if monetary policy loses its flexibility, it loses one of its big advantages.

The current members of the MPC are all eminently qualified, and the selection process for external members is rigorous. But the mavericks of the early days of the MPC, when members were chosen by Ed Balls and Gordon Brown, with advice from officials, are no more. There is more “groupthink” on the MPC than there should be.

That and the impression it sometimes creates of being an ivory tower institution with too little awareness of what is happening in the world and in financial markets (which have been recently wrongfooted by the Bank’s communications) is not healthy. The Bank should engage more in the debates that are happening outside its four walls, including whether the massive QE programme it launched in response to the pandemic compromised its independence. I do not think it did, but others do.

These are problems that can be fixed and as noted, there should no question of going back on independence. It has mainly served us well over 25 years. It can continue to do so.