Following the non-inflationary calm of its first decade of independence, the Bank of England has coped with the 2008 financial crisis, the Covid-19 pandemic and, more recently, the rise in inflation. It has implemented massive quantitative easing and acquired significant extra responsibilities for supervision and financial stability. It is time to review present arrangements and particularly the relationship with the Treasury.
Many claim that an independent Bank is more likely than politicians to take difficult decisions by raising interest rates to control inflation. Some form of central bank independence is the norm in peer economies. Attempts to curtail or modify Bank independence would take a risk with the markets even if a plausible case could be made. Given the vulnerability of the UK markets and economy to a loss of confidence following the Liz Truss experiment, any change in the BoE’s remit should not be taken lightly, if at all.
When in the 1980s Bank operational independence was first seriously discussed in the UK Treasury, an influential official wondered aloud why there could not also be independent central Treasuries that would be given a target path for the budget balance: its officials would adjust a chosen set of tax rates and public expenditure categories to achieve the target path. Elected politicians would set the objectives for the independent fiscal and monetary bodies and make the appointments to them, but have a diminished role in domestic macroeconomic policy.
The suggestion of an independent fiscal authority was not made entirely in jest. The argument against is that it would not be acceptable in a democracy for decisions on taxes and vital services to be made by unelected officials whom voters could not hold to account. Yet the position with monetary policy is similar. Rises in interest rates can have large adverse effects on living standards, especially for those with mortgages, while benefitting those with savings. Furthermore, monetary policy changes can have significant effects within the corporate sector, especially for banks.
A separate argument is that monetary policy can be highly technical and is best left to experts rather than politicians. However, fiscal policy – particularly tax – can be just as intricate and technical.
The notion that expert officials are more reliable in curbing inflation is not wholly borne out by the UK’s record of the last 50 years. In the first inflationary spike of the 1970s neither ministers nor senior officials at the Treasury or the Bank wanted to tighten monetary policy sufficiently. In the second inflationary spike, ministers of the incoming Margaret Thatcher government in 1979 implemented a drastic tightening of monetary policy that was opposed by some senior officials in both the Treasury and the Bank.
The jury is still out on the handling of the current inflationary spike. In 2021 the BoE was slow to acknowledge rising inflation (along with many of its peers overseas – central bank groupthink) and to tighten policy. Recently, with inflation substantially above its target range, some members of the Monetary Policy Committee have voted for small, and even zero, interest rate rises from historically low levels, which has not helped the Bank’s counter-inflation credentials.
QE was used by the BoE and other central banks in the financial crisis and pandemic. It could be necessary again. Clarification and codification of the responsibilities of the Bank and the chancellor is needed.
The nature of the current ambiguity on responsibility was illustrated in November 2020 when the Bank announced a further increase of £750bn in its asset purchase facility. The published letter from the governor to the chancellor said:
‘I would be grateful if you could authorise the changes in size and composition of the APF that I have requested in this letter and for the purposes of transparency and accountability confirm that the government will continue to indemnify the Bank and the APF for any losses arising out of or in connection with the facility.’
While Bank/Treasury agreement on such a huge policy decision was sensible, this was hardly the language of operational independence. The blanket request for authorisation of the APF and for a 100% guarantee against loss gave the chancellor an important role in the operation of monetary policy. What would have happened if he had declined to approve the increase or the 100% guarantee against loss? Why did the Bank feel it necessary to seek a 100% guarantee against loss while, for instance, the European Central Bank had no guarantee for its QE?
The position with quantitative tightening is different. No formal Treasury approval appears necessary for these transactions. However, at a time of great sensitivity about the quantity of gilts being marketed there is a case for coordination of the government’s borrowing and the BoE’s QT.
When the Bank became independent – when both inflation and government borrowing were well controlled – there was a view that monetary policy alone should be used for controlling inflation and that fiscal policy should be set in a medium-term context and not used for short-term management of the economy. This was the opposite of the post-war Keynesian consensus that ascribed the role of short-term macroeconomic management to fiscal policy.
Neither view works with the economic problems of recent years. Most significant fiscal events have elements of short-term macro management, though these are combined with frequently changing medium-term fiscal rules. The government is using short-term fiscal measures to hold down prices and to protect real incomes. There is a case for coordinating such fiscal policy decisions with the monetary policy decisions of the central bank. Who takes the final decisions on any coordinated anti-inflation package is the crucial question.
To maintain market confidence in fiscal and monetary policy, a review of how the BoE and Treasury operate should be cautious and well planned. It should aim to agree rules and procedures for when both monetary and fiscal policy are being used for short-term macroeconomic management. It should devise a more formal coordination of Treasury and Bank operations that affect the gilt market at a time of QT.
Simultaneously the extent and nature of the BoE’s operational independence in its supervisory activities should be reviewed and codified. There should be clear ground rules for all these eventualities. To maintain market confidence the arrangements for coordination or joint decision-making in any area need to be transparent, defensible and known in advance.
Peter Sedgwick was a senior Treasury official, a Vice President of the European Investment Bank 2000-06, Chair of 3i Infrastructure PLC 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.