After 25 years of comparative calm, Britain is now coping with the first inflation crisis since the Bank of England was made operationally independent in 1997. This adds to tests for macroeconomic management already posed by the 2007-08 financial crisis, the 2016 decision to leave the European Union and the 2020 Covid-19 pandemic.
The UK’s inflation rate is now higher than in comparable economies. Despite efforts to curb public sector borrowing, the government debt to gross domestic product ratio is at a 60-year peak. Last autumn’s ill-judged tax cutting budget led to one of the worst upsets in the gilt-edged market since the Labour government sought a loan from the International Monetary Fund in 1976. Long-term interest rates are close to levels seen during last autumn’s crisis.
In view of the disappointing records in controlling inflation and public borrowing it is time to review the relationship between the Treasury and Bank of England. Important changes are needed to the Bank’s role in economic policy, applied both to selecting its leadership team and to the key question of coordinating fiscal and monetary policy. There should be a formal Treasury-Bank consultation before fiscal events with the main conclusions published.
Any such changes might be criticised as reducing the Bank’s independence and moving out of line with other big economies. Such coordination of fiscal and monetary policy is almost impossible in the US and EU in view of their constitutional structures. In the UK such a step is constitutionally possible. Britain’s recent shortcomings make previously unthinkable actions now worthy of active consideration.
A comparison with 1997 is necessary. When Gordon Brown, as chancellor of the exchequer, announced the framework for Bank of England independence, he said monetary decision-making would be ‘more effective, open, accountable and free from short-term political manipulation’. The almost universal view was that this would ensure timely and fearless monetary policy decisions, particularly if there was a need to raise interest rates. The chancellor and Treasury would have no role in managing short-run economic fluctuations or controlling inflation, roles that would belong to the Bank.
Bank has reacted less decisively to inflation than post-1979 Conservative chancellors
We now have the first real test for that regime. The Bank has reacted slowly, insufficiently and arguably less decisively to the rise in inflation than Conservative chancellors did in in the post-1979 era where the Bank was under Treasury control. The series of mini upward steps in UK interest rates – while comparable with tightening by the Federal Reserve and European Central Bank – has allowed core inflation to rise substantially after most commodity prices have fallen significantly.
Despite this, some members of the Bank’s monetary policy committee have frequently voted against rate rises, further weakening the Bank’s counter-inflation credibility. The Bank maintained quantitative easing for too long. It is now belatedly reducing its stock of securities by around £80bn a year, while the UK government still has a massive public borrowing programme.
Rishi Sunak, the prime minister, and Jeremy Hunt, the chancellor, have been doing the heavy political lifting in explaining and justifying rises in interest and mortgage rates. The Bank’s public efforts to justify and persuade have had limited impact. Eddie George, the Bank’s first independent governor, would not willingly have ceded this role to ministers. In the UK political context, it has perhaps always been unrealistic to expect the electorate to accept painful policies without ministers – whom they can vote out of office – taking full responsibility.
The Treasury has been encountering even more intractable problems with fiscal policy. The UK’s public debt rise is due in large part to the pandemic and the Ukraine war. The consequence of protracted large-scale public sector borrowing, rising interest rates and the uplift to indexed gilts from high inflation has been rocketing debt interest. There is limited support for measures to contain borrowing. The electorate and companies show no sign of willingness to accept higher taxes (unless paid by others). Simultaneously the demands for additional public spending for health, education, defence, public sector pay and many more public services are enormous.
Most potential new sources of tax revenue are either of short duration (such as windfall taxes) or have potentially damaging consequences (the risk of driving activities and associated tax receipts out of the UK). For years to come, UK chancellors of whatever political persuasion will face a constant struggle to keep borrowing in check. This will be difficult as many believe that governments can relieve almost any economic and social problem and offset any shock through fiscal measures. If enacted, these could increase overall demand and influence inflation (for instance energy subsidies). Such action would take the Treasury even more into territory that post-1997 was supposed to be the responsibility of the Bank of England.
The UK’s huge borrowing in the financial crisis and the Covid-19 pandemic appeared to support the assumption that the UK government’s reputation and credit worthiness would allow unlimited borrowing without adverse effects. However, the Bank’s massive simultaneous asset purchases mean that much of this debt did not have to be absorbed by the markets. With the Bank now reducing gilts holdings and yields close to autumn 2022 levels, fiscal policy needs to be highly cautious. This is not a comfortable message for those wishing for expanded public services or tax cuts.
Bank’s reputation and professionalism need to be reestablished as soon as possible
Against this sombre background, what needs to be done?
First, the Bank’s reputation and professionalism need to be reestablished as soon as possible. Senior leadership positions need to be filled by individuals with longstanding experience and knowledge of macroeconomic and monetary policy as well as the financial system. Candidates need to have very strong presentational skills so the Bank does not cede to the prime minister and chancellor the justification for monetary policy. Before appointment candidates should explicitly and publicly support the government-ordained Bank’s inflation control remit and not appear to replace it with their own. It is difficult to square the votes of some MPC members against interest rate rises with a full acceptance of the Bank’s remit. There should be an independent review of procedures for the Treasury to draw up shortlists for vacancies in senior positions.
Second, the Bank’s disposal of gilts through quantitative tightening needs to be fully coordinated with the government’s borrowing and gilt issuance. When the government made the Bank independent in 1997 it gave to the newly created Debt Management Office the Bank’s previous role in managing the gilts programme. The Bank’s QT disposals should be closely coordinated with the DMO’s activities and, if the latter thinks necessary, modified as a result. Such consultation may occur informally, but open and explicit arrangements are preferable.
Third, all parties should recognise that fiscal policy can influence inflation and aggregate demand. As a result, coordination is needed between the government’s budgetary policy and the Bank’s anti-inflation policies and interest rate setting. How fiscal and monetary policy could be coordinated was always the unsolved problem of 1997. What form this coordination should take and who should decide in case of disagreement are the key issues.
All these considerations should be on the agenda not just of the present government but also of the Labour politicians who may take power after a general election, likely in autumn 2024. It is not too soon to start a debate about issues which matter greatly to the future of Britain.
Peter Sedgwick was head of the UK Treasury’s Forecasting Team 1986-90, its International Finance Group 1990-94 and a Deputy Director of its Public Services Directorate 1994-99. He was a Vice President of the European Investment Bank 2000-06, Chair of 3i Infrastructure 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.