There is nothing wrong with Bank’s mandate – it just has to do it better

Quarter of a century of independence on monetary policy is a cause for celebration

An important anniversary came around last week, namely 25 years since then-chancellor Gordon Brown announced that the Bank of England was being given operational independence. Should we be celebrating?

In previous decades, monetary policy decisions were taken by the chancellor of the day, albeit with advice from the governor of the Bank. Under this regime, interest rates would sometimes be changed to fit in with the political requirements of the government – including the desire for reductions during Conservative Party conference week.

Things began to change in 1993, after Britain’s ignominious exit from the European Exchange Rate Mechanism (ERM).

For the next four years, regular discussions about monetary policy between the chancellor, Ken Clarke, and the governor, Eddie George, were minuted and published. This regime, which became known as “the Ken and Eddie show”, represented independence-lite.

It was only in 1997 that full independence was granted.

But how independent is the Bank in reality? The chancellor chooses the MPC members and he appoints – and can reappoint – the governor. He also sets the target that the Bank is supposed to hit.

Potentially of much more importance, over recent years the Bank has bought huge quantities of gilts, thereby effectively financing the government by “printing money”. Admittedly, this has been at arm’s length, rather than directly.

Even so, it has blurred the distinction between monetary and fiscal policy.

Without this quantitative easing (QE), the Treasury would have faced much higher borrowing costs.

You can readily see how this policy could undermine Bank independence. It doesn’t look good to be providing cheap finance to a cash-strapped Treasury.

Yet, even though the extent and longevity of the policy may have been misjudged, there was a legitimate monetary policy case for QE and it appears to have been freely chosen by the Bank, rather than being adopted following a nudge, let alone a diktat, from the Treasury.

Reflecting on the whole period of the Bank’s independence, it looks as though things have gone very well. The average rate of CPI inflation has been 2pc, bang in line with the current inflation target.

Mind you, for most of the last 25 years, the Bank has been operating under extremely benign inflationary conditions, with globalisation in full swing, technological advances bringing costs down and trade unions quiescent. And inflation has been anything but steady at the target. In September 2011 it reached a high of 5.2pc, while it briefly dipped below zero three times in 2015.

Indeed, remarkable though it now

‘Reflecting on the whole period, it looks as though things have gone very well’

seems, at that point there was thought to be a serious danger of the economy slipping into persistent deflation.

Meanwhile, in pursuing its inflation target, the Bank is also obliged to have regard to a second objective, namely to support the government’s policies on output and employment. Yet the UK fell into recession in 2008-9 and it came close in 2012, before the Covid-induced major drop in output in 2020.

More tellingly, the latest inflation figure is 7pc, the highest since independence. And it looks likely to rise to 10pc or higher. So perhaps it is just as well for the Bank to get its celebrations in quickly.

Anyway, given the last 25 years’ experience, what about the future? Should the current monetary policy regime be reformed? There is a legitimate debate about whether 2pc inflation is the right target.

Some notable economists have argued that it should be increased to 3pc or even 4pc.

They allege that this would help to facilitate shifts in relative prices, while also giving more leeway before inflation dips into negative territory, giving rise to the various problems associated with a possible need for negative interest rates. I don’t find this compelling. Although there is no God-given reason why the inflation target should be 2pc, this figure is low enough for people to almost forget about inflation. Whereas 4pc is a different kettle of fish. At that rate, over 10 years your money loses about a third of its value.

Another suggestion is that, instead of targeting CPI, the Bank should target nominal GDP, which brings together changes in both the price level and output. Under such a target, if inflation rises at a time of weak output, the Bank would be under less pressure to raise interest rates.

There is something in this argument but again, in the end, I don’t find it convincing. Nominal GDP is not widely understood. It isn’t exactly the subject of frequent discussions down the Dog and Duck. By contrast, there is a pretty good understanding of what the CPI is trying to measure. Similar objections apply to the idea of the Bank being set an objective for a specified level of prices that rises over time, rather than for a specified rate of change at all times.

Sometimes, people suggest that the MPC should be given a raft of other objectives, from saving the planet to improving productivity or solving the housing crisis. Unfortunately, even at the best of times, monetary policy is a blunt weapon and it has only one dimension, or at most two – namely interest rates and the ability to buy and sell financial assets. With the best will in the world, these two instruments cannot be directed towards multiple objectives.

Two areas where there is room for improvement are the selection of MPC members and the way they operate. In recent years, too many appointees have been consensus thinkers. Unsurprisingly, the Bank has succumbed to groupthink.

Moreover, it has paid too much attention to economic models and has been insufficiently aware of what’s going on outside its hallowed corridors. If the Bank has been complacent about the inflationary danger and operated too lax a monetary policy for too long, these are the major reasons why.

That said, especially given what went before, the last 25 years of monetary management have been broadly successful.

Here’s wishing the MPC a (slightly belated) happy 25th birthday.