Let the Bank strike a balance between savers and borrowers
It is now nearly 20 years since the incoming Labour government took the bold step of giving the Bank of England independent control over monetary policy. The Monetary Policy Committee (MPC) was established in May 1997. From then on, the Chancellor of the Exchequer no longer had a say in setting the level of interest rates. He did, however, specify the remit for the MPC – setting out the objectives which the committee should follow in taking its decisions.
The initial remit of the MPC was to keep RPIX inflation at 2.5pc. In 2004, a new inflation measure was adopted – the consumer prices index – and the target was set at 2pc.
In the period before the financial crisis, it appeared relatively straightforward for the MPC to hit these inflation targets. Over the period 1997-2007, the economy enjoyed stable inflation, healthy growth, rising living standards and reasonably low unemployment.
But the stability which the economy enjoyed from 1997 and the 2007 was something of an illusion. Under the surface, problems were developing in the financial system which led to the global financial crisis and the recession of 2008/9. Inflation became more volatile from 2008 onwards – fluctuating from over 5pc to less than zero. Economic growth has been disappointing. In the recovery which has been under way since mid-2009, GDP growth has averaged 2pc a year compared with nearly 3pc in the 10 years to 2007.
I was a member of the MPC during the financial crisis and we took some quite dramatic steps to help the economy recover from the 2008/9 global economic downturn.
Interest rates were cut to 0.5pc and money was injected into the financial system via quantitative easing (QE). At that time, however, interest rates were expected to bounce back within a few years to 3pc-4pc. That has not happened – indeed the most recent step taken by the MPC has been to cut interest rates further and inject even more QE.
For most of the time since 1997, however, MPC policies were not hugely controversial. There were occasional differences in opinion on the committee. For example, I was part of a minority group arguing for an early rise in interest rates in 2010/11. But within the political system, there has been general support for the independence of the Bank of England and broad approval for the actions taken by the MPC.
So it was surprising to hear our new Prime Minister, Theresa May, making some apparently critical comments of interest rate policy in her recent conference speech. She said that while “super-low interest rates and quantitative easing provided the necessary emergency medicine after the financial crash, we have to acknowledge there have been some bad side effects… A change has got to come. And we are going to deliver it.”
That sounded like an open challenge to the Bank of England’s monetary policy and the Governor of the Bank of England, Mark Carney, responded quite quickly. He pointed out that “the objectives are what are set by the politicians. The policies are done by technocrats.” In other words, if you want to change the remit of the Bank of England, go ahead. But do not criticise our policies.
That was followed by an article from William Hague in The Daily Telegraph earlier this week, which listed 10 reasons why low interest rates and QE were having a negative impact on the economy and society. In turn, the Bank of England then published a defence of its quantitative easing policies in the form of a working paper by its chief economist, Andy Haldane, and other former and current Bank staff.
It is not good for the pound and for economic confidence if the policies of our independent central bank appear to be under attack from senior politicians. But the points made by May and Hague are good ones. There have been unintended consequences from a prolonged period of very low interest rates, backed up by repeated bouts of QE. These adverse impacts on savers, on pension funds, on government bond yields and property prices should be taken into account by the Bank of England in setting its interest rate policy.
So what is the way forward? I strongly support the independence of the Bank of England and the freedom to set monetary policy without political pressures – not least because of my first-hand experience on the MPC. But other aspects of the way in which the MPC operates could and should be reviewed by May’s government.
First, it is not clear that the 2pc inflation target is the right benchmark for the MPC since the financial crisis. If wages are growing at 2-3pc, an inflation target between zero and 1pc may make more sense.
Economists worry that this may take us closer to deflation, but the threat of falling prices has been greatly exaggerated since the financial crisis. Deflation is the “dog which has not barked” since the traumatic events of 2008/9.
Second, there is a strong case for the Government building into the Bank of England’s remit an objective of ensuring a positive real interest rate – ie setting the official Bank rate at a level which is at least higher than the rate of inflation. This would help ensure that savers can earn a rate of return which compensates them for price rises and that pension funds can also look forward to positive real returns on government bond yields.
At present, the UK has a 2pc inflation target and interest rates close to zero. Our economy would be healthier if these figures were reversed – 2pc interest rates with zero inflation. It is worrying that Carney and other MPC members have said they will turn a blind eye to the impact of a falling pound on inflation. Savers and pension funds worry that the Bank’s independence is persistently being used to the advantage of borrowers, disadvantaging those who are trying to build up savings.
It would be wrong, though, for politicians to undermine the independence of the Bank of England – which has generally worked well. Instead, they should review the rules under which the MPC operates. We need monetary policies that promote a more healthy balance between saving and borrowing in our economy.
‘There is a strong case for building into the Bank’s remit the objective of a positive real interest rate’