How the Bank of England has failed to control inflation. And what should be done to reform it.
This week sees the Bank of England celebrate 25 years of independence. Quite rightly, the current rise in inflation has raised questions about whether it is time to reassess its remit and governance.
There has been a rise in inflation across western economies. That this is more than a UK issue should not divert attention from where the problem lies.
If you are driving a car and approach a red light and decide to not only ignore the signal to stop but put your foot down on the accelerator, you are driving dangerously. That some other cars may do the same does not change that fact. It is not safety in numbers, but is more likely to cause greater carnage. Last year, in monetary policy terms, central banks went through the red light – with their feet down on the accelerator. The Bank of England was near the front.
At that time, it was clear that our economy was recovering and inflationary pressures building. The supply-side shock triggered by the pandemic was already evident. The correct policy would have been to tighten policy, not add fuel to the fire by increasing Quantitative Easing to a mammoth £895 billion.
The question I posed then was: which ‘p’ was this inflation? Would it pass-through, persist or become permanent. The Bank strongly believed it would pass through quickly. It was evident it would persist. It was unlikely to be permanent because of intense global competition but, even if inflation persists, once it then eases it may settle at a higher level than before, say nearer three per cent to four per cent than one per cent to two per cent.
The danger, as was clear at the time, was that even if the initial cause of inflation is a supply-side shock, action needed to be taken to prevent cost-push inflation by which firms raise prices to pass on higher costs, or second-round effects allowing prices and inflation expectations to creep higher. Effective communication as well as clear actions were called for. We got neither.
What are the lessons and implications?
Consider the 1970s. It may be hard to believe, but Britain began the 1970s as the low inflation country of Europe. Monday 15th February 1971 was Decimalisation Day, when we moved from 240 pennies in the pound to 100 new pence.
Ahead of that day, I remember paying my bus fare with pennies that had been minted not just in the early part of the twentieth century but some in the nineteenth century too, with Queen Victoria’s head on them. That such old coins were still legal tender was testimony to how well Britain had kept inflation under control.
Apart from the First World War, when annual inflation averaged 15.3 per cent in the UK, only the 1970s saw high inflation, averaging an annual 12.5 per cent during that decade. There is no reason why, with the right policies we cannot return to being a low inflation economy.
The 1970s showed that inflation is deadly. That’s why the complacency with which the Bank treated it last year was wrong. It is felt by everyone, with the poor and those on fixed incomes like pensioners suffering the most.
Another lesson is that the measures necessary to control inflation are deeply uncomfortable, often requiring sharply higher rates, with damaging economic consequences. Nowadays, with borrowing higher, the economy is not only vulnerable to higher rates, but can be impacted sooner as policy tightens.
UK policy rates are currently only 0.75 per cent, while annual consumer price inflation in March was seven per cent, ten times higher than its rate of 0.7 per cent a year ago. And it will head higher.
Harold Wilson, Edward Heath and Jim Callaghan all lost elections because of their inability to control inflation. A central feature of the two general election campaigns in 1974, and even of that of 1979, was the use of a shopping basket to show how the Government had failed. Don’t be in any doubt as to who pays the price for a failure to control inflation.
Given this background, and how important monetary policy is in everyday life, one might think Westminster would pay more attention to the Bank of England – to how it is governed and keeping inflation under control. It is now as the cost-of-living crisis bites and the economy slows sharply.
The weekend saw much coverage of the 25th anniversary of the Blair landslide in 1997. An early decision – on 6th May 1997 – was to award operational independence to the Bank of England.
Although a surprise – having not been mentioned in the campaign – independence had been a topic of discussion for some time among economists. There were pros and cons. It would embed low inflation expectations, but there was a need for transparency and democratic accountability.
Even the Bank’s own Quarterly Bulletin in 1995 had carried an article by a leading economist, Robert Barro, showing that it was not independence but often an external factor that was the driving force behind inflation. Indeed, China’s entry into the World Trade Organisation in 2001 contributed to intense competition – helping to drive inflation down globally and in the UK for much of this century.
Inflation has averaged two per cent over the last quarter century. While welcome, this should not divert attention from how the economy has suffered the consequences of three major policy mistakes from the Bank.
First, monetary policy has fed rampant asset price inflation, in financial markets and property. Alongside low property supply, this has fed intergenerational inequality.
Second, a cheap money policy through low interest rates and Quantitative Easing has fed financial instability as markets do not price properly for risk.
Third, the Bank’s recent policies have fed inflation.
Attention usually focuses on the Monetary Policy Committee and interest rates. Thus, the Bank’s other policy committees on prudential regulation and financial policy are too often freed from scrutiny – as is the interaction between these policies. The economy, after all, is significantly affected by the prudential controls placed upon on banks, and peoples’ ability to borrow has been impacted by micro-prudential regulations.
While the Bank, in recent years, has played a welcome role in how finance can help achieve the green agenda, there are other important areas that the Bank should confront. Not least among these is the low level of commercial lending to small firms. It should also be more of a cheerleader for the Square Mile.
Now, it is time to ask whether the Bank’s inflation targeting regime has run its course. I favour a new remit based on a target for nominal GDP. An anti-inflationary monetary policy remains critical, but change is well overdue.
In this much-needed review of the Bank there needs to be a reassessment of its governance, transparency and accountability.
The Bank’ governance is overseen by the Court, but this is rarely held to account, and would appear to pay only lip-service to diversity, not least in thought. Groupthink can be a problem with policymakers. In my view, one might ask if the Bank’s historic underrepresentation of those from working class backgrounds in senior positions hinders how it sees its policies affecting those on low incomes. Its communications too have caused problems. Yet, effective communication is critical – not only to the public and financial markets, but to global audiences too.
This article was originally published in Conservative Home