The Bank of England, forced to raise interest rates for the 13th consecutive meeting to help quell persistent inflation, faces its most serious crisis of confidence since 1992, when the UK was forced out of Europe’s exchange rate mechanism.
The 0.5 percentage point rise on 22 June, taking bank rate to a 15-year high of 5%, was steeper than the 0.25 points predicted by many economists. The Bank’s hand was forced by a surprisingly high 8.7% annual inflation rate for May and a fresh rise in the core inflation rate, in contrast to falling core inflation in the US and the euro area.
The problems for the Bank are in some ways more acute than when it exhausted foreign exchange reserves on Black Wednesday, 16 September 1992, after a vain defence of sterling’s ERM rate ordained by the Conservative government in 1990. Since 1997, the Bank of England has been operationally independent and responsible for fighting inflation.
Andrew Bailey, the Bank’s governor, under fire in 2022 from the short-lived government of Liz Truss, was granted a temporary reprieve through deft handling of last autumn’s UK financial market unrest. Truss consciously failed to learn any of the lessons from Black Wednesday. As government bond yields skirt levels in last year’s upsets, bringing politically sensitive upward pressure on mortgage rates, Bailey is coming under renewed criticism from the media and politicians over a relaxed attitude to incipient inflation in 2021.
The much predicted peril of high inflation coupled with steeper unemployment and recession now looks like becoming reality. Bailey is coming under attack above all over failure to rein the huge rise in the Bank of England’s balance sheet through quantitative easing – purchases of government bonds – in 2021.
Sunak’s inflation promise may return to haunt him
Rishi Sunak, prime minister, who took over from Truss after she was forced out in October, faces a political backlash from higher interest rates as well as four difficult by-elections next month. A member of parliament only since 2015, Sunak exudes a technocratic image aimed at reassuring voters after the chaotic premierships of Truss and her disgraced predecessor Boris Johnson. But he still has much to learn about how to be a politician. His promise to halve inflation to 5% this year may return to haunt him.
The Bank’s difficulties have been exacerbated by a legacy of financial market nervousness after the September-October strains that caused the departure of both Kwasi Kwarteng, then chancellor of the exchequer, and Truss herself. But many of Bailey’s public statements over the last three years have been judged as weak, displaying a lack of public relations skills and complacency that have undermined public confidence.
In addition, the Bank has faced charges from some quarters over alleged inaction to control risks in the UK pension fund industry that became evident in last autumn’s volatility. This applies in particular to pension funds’ use of liability-driven investment strategies – even though the main responsibility here is carried by the Pensions Regulator, the UK’s lacklustre pensions regulatory body.
Sniping against Bailey restarting from ruling Conservatives
Jeremy Hunt, chancellor of the exchequer, said he fully supported the Bank’s move. But sniping against Bailey is restarting among politicians from the ruling Conservatives. The party is deeply unpopular after a string of political and economic setbacks, including lack of success from Britain’s departure from the European Union consummated in 2020-21.
Britain’s imbroglio underlines elements of truth in the remark in 1996 by Theo Waigel, Germany’s then finance minister, to Gordon Brown, later Labour chancellor of the exchequer. Just before the 1997 election, which led to a Labour victory and Brown making the Bank operationally independent, Waigel told him that independence was a useful tool to allow the government to blame the central bank for disagreeable interest rate increases.
‘We know this is hard,’ Bailey, said on 22 June pointing to difficulties for people with mortgages. ‘But if we don’t raise rates now, it could be worse later.’ The bank’s monetary policy committee – which voted seven to two in favour of the increase – said: ‘There has been significant upside news in recent data that indicates more persistence in the inflation process.’
When she took office in September, Truss toyed with the idea of replacing Bailey, whose eight-year term runs until 2028, until she realised that his legal position made removal highly difficult. Instead, she forced Kwarteng to sack Tom Scholar, permanent secretary at the Treasury.
Sunak is unlikely to be bold enough to prompt a showdown with Bailey. However, should the Labour party come to power after an election thought likely to take place in October 2024, an incoming Prime Minister Keir Starmer could prevail upon Bailey to make way.
Two possible replacements are Minouche Shafik, a former Bank of England and UK government official who is about to become president of Columbia University in New York, and Shriti Vadera, a former government official and investment banker, now chair of UK insurance group Prudential.
David Marsh is Chairman of OMFIF. Meghnad Desai is Emeritus Professor of Economics at the London School of Economics and Political Science, Chair of the OMFIF Advisory Council and Crossbench Peer in the House of Lords. John Nugée is a Senior Adviser to OMFIF and former Chief Manager of Reserves at the Bank of England.