Since the Bank of England achieved operational independence in 1997, it has been solely responsible for controlling inflation. The UK’s financial sector management has faced two major tests since then. First was the 2008 financial crisis, followed by some larger banks being rescued by the Treasury, the start of quantitative easing and – eventually – the role of banking supervision being restored to the Bank of England. The second test is occurring now, following a surge in inflation. Changes should result from the painful lessons being learned.
The post-1997 arrangements make effective coordination of fiscal and monetary policy virtually impossible. This is particularly the case in circumstances where both fiscal and monetary adjustments are needed.
Applying lessons from the current crisis
Not only was the BoE’s initial response to the current threat of rising inflation too little and too late, but the failure to embed an adequate framework for coordination of fiscal and monetary policy has hampered the response to the inflation crisis. As a result, far too much of the burden of reducing inflation is being borne by monetary policy. This means that actual and potential mortgage holders and the housing industry are suffering while other, mainly older, groups are relatively unaffected and may even gain from the rise in interest rates.
There is a stark choice that cannot be evaded in the UK. The first option is to make institutional changes to enable fiscal and monetary policy to be coordinated and spread the inflation-adjustment process fairly. The second is to leave the institutional arrangements as they are and concentrate the bulk of the pain as inflation is reduced on mortgage holders and those of working age.
The institutional change needed is for the main fiscal and monetary policy decisions to be taken together twice a year by the Treasury and the Bank of England, with the chancellor of the exchequer taking overall responsibility and being accountable to parliament for these decisions.
Rises in interest rates exacerbate intergenerational unfairness
The Bank’s only active tool for monetary policy as it tries to reduce inflation has been to raise short-term interest rates. The excessive reliance on interest rate hikes has spread the burden of adjustment unevenly through the economy in a way that is both inefficient and unjust. Even though higher interest rates affect the business sector, any policy to reduce inflation is bound to have its principal effect through curbing consumer spending, given its importance in gross domestic product.
Higher short-term interest rates eventually produce higher mortgage rates, though more slowly than in the past, given the increase in fixed-rate mortgages. This causes defensive behaviour by mortgage holders that restricts other spending. The disincentive process of rising short-term interest rates eventually reduces house-building, causes house prices to fall and, if only through the prevalence of buy-to-let properties, has effects in the private rental sector.
The effects on those without mortgages – specifically, older property owners that have paid off mortgages, have financial savings and have ceased work – are quite different. While they may be disadvantaged by the indirect effects of interest rate rises on the rest of the economy, the direct effect can be to raise their incomes. Therefore, when monetary policy is being tightened, it exacerbates inter-generational unfairness that is already a serious problem for the UK economy.
The uneven effects of raising interest rates could and should have been anticipated in 2021 and 2022 by looking at the lessons of policy tightening by Chancellor of the Exchequer Nigel Lawson in the late 1980s. His three decisive rises of one percentage point concentrated the effects of the monetary policy tightening on mortgage holders and the housing market. This resulted in particularly severe falls in house prices and the emergence of considerable negative equity.
A reformed system for coordinated fiscal and monetary policy
The chancellor’s two principal macroeconomic statements to parliament each year should combine fiscal and monetary policy changes so that any required disinflationary pressure is applied as evenly as possible across the economy and does not disproportionately bear down on people in work with mortgages. This can only be achieved through changing fiscal policy instruments as well as interest rates. Between these two main macroeconomic announcements the BoE should be free to alter short-term interest rates as it considers necessary and market conditions dictate. At all stages the Bank’s views should be fully publicised even if these differ from those of the chancellor.
There is a range of fiscal instruments that could help to manage demand. Short-term variations in public expenditure – particularly cuts – are difficult to achieve in practice. Rises in indirect taxes feed directly through to measured inflation, leading to increases in public expenditure through benefit uprating and higher interest rates on indexed gilts. A temporary surcharge on income tax payments would have fewer disadvantages than other fiscal measures and would spread the burden of adjustment widely, particularly to those without mortgages.
It may be argued that informal consultation between the BoE and Treasury can and does occur and that there is no need to change current practice. Even if they occur, such informal consultations are no substitute for transparent arrangements for fiscal or monetary coordination.
Despite the strong case for a more balanced approach to inflation reduction, chancellors and their senior officials are likely to recoil in horror at curtailing central bank operational independence and the prospect of having to raise taxes as part of a counter-inflationary strategy. The point that central bank independence is the norm elsewhere has limited force given that constitutional structures in the US and European Union make the coordination of fiscal and monetary policy impossible – something that is not the case in the UK.
The UK macroeconomic framework needs major transformation so that any future effort to reduce inflation to its target level is achieved both more efficiently and equitably.
Peter Sedgwick was a senior UK Treasury official, Vice President of the European Investment Bank from 2000-06, Chair of 3i Infrastructure PLC from 2007-15 and Chair of the Guernsey Financial Stability Committee 2016-19.
This is the final instalment in a series of commentaries on the Bank of England and the UK Treasury. Read the first here and the second here.