2024 will see a general election in the UK. Whether the opposition Labour party or the incumbent Conservatives lead the resulting government, it will be time to review the institutional arrangements for monetary and fiscal policy following problems and failings in recent years.
While the Bank of England will probably take some comfort from the recent fall in inflation, its response to the initial rise was slow and unsure. Its handling of interest rate policy and quantitative easing/tightening should be thoroughly assessed and new arrangements proposed where performance could be more effective, more transparent and better presented.
Lessons also need to be learned on how the Bank and Treasury can better coordinate fiscal and monetary policy so that the burden of reducing inflation, when necessary, does not fall disproportionately on those of working age with mortgages. This would involve Treasury and Bank co-operation in policy decisions even if this alters the Bank’s operational independence.
How appointments are made to senior Bank of England posts also needs to come out of the shadows. With dire fiscal prospects facing the UK, the next government needs to do more than hope that vague strategies to raise growth might in time increase tax revenues. The government debt-to-gross domestic product ratio needs to be put on a firmly downward path. Completely inconsistent aspirations for tax levels and public services need to be dealt with by moving towards charges and hypothecated revenues for the major services.
Independence in a crisis
The most sensitive problem for any review of UK macroeconomics is the independence of the Bank of England. Central bank independence is considered best practice internationally. It had been widely assumed that an independent Bank would quickly and fearlessly take difficult decisions on interest rates. Recent experience has called this assumption into question.
A review of UK macroeconomic policy would need to examine whether, given UK constitutional arrangements that permit coordination of monetary and fiscal policy, more effective arrangements could be found. It may be that in a financial crisis, and particularly when policy tightening is urgent, the normal separation of responsibilities is suspended and the chancellor and bank governor – with the former having the final say – decide how fiscal and monetary policy (including any unusual measures such as QE/QT) are altered to deal with the problems.
The political parties will want to campaign with their proposals for successful macroeconomic management. These should still leave scope for a review of the institutional arrangements after the election. The review could be swift and should benefit from full consultation with the Bank of England, the Debt Management Office and the Office for Budget Responsibility.
The exercise should not follow the example of 1997 when Bank of England independence was announced at the beginning of the Labour government and the important modalities (removing supervision and the responsibility for selling government debt from the Bank) were worked out subsequently. The conclusions of the review and any changes to the role and responsibilities of the various institutions should be approved by parliament, regardless of whether legislation is required.
How to balance interest rate policy and QE
The operation of monetary policy since the 2008 financial crisis and the pandemic has involved QE and, more recently, QT alongside more conventional changes in short-term interest rates. The UK framework for this dual instrument approach is a muddle and badly needs to be reviewed.
Unlike the Federal Reserve and the European Central Bank, the Bank of England has sought and obtained indemnities from the Treasury against losses on its QE/QT transactions. This has had significant fiscal implications as the Bank’s operations first led to gains and more recently to losses. Whether the Bank of England needs or even benefits from a guarantee when other central banks do not have one should be urgently reviewed.
During the period when it was purchasing assets on a considerable scale, the Bank overtly sought not just a Treasury indemnity for its QE purchases but the chancellor’s approval for the whole operation. In effect it diluted its independence in obtaining a guarantee for QE operations. However, as it turned to QT – arguably too late, as with its interest rate hikes – no such Treasury approval was sought. There seems to be no explanation for this asymmetric arrangement.
The operation of QT has highlighted another problem. By its asset purchases during the pandemic the Bank was, whether deliberately or not, helping to fund the government’s enormous fiscal deficits. With QT it has been exacerbating the problem of financing the government’s continuing deficits. It is currently selling assets at a rate of £100bn a year, substantially adding to the over £230bn of gilt sales that the DMO expects to make in the current financial year.
There is apparently close co-operation between the Bank, the DMO and the Treasury over these sales. But such informal and behind the scenes co-operation is reminiscent of an earlier age and should be replaced with transparent arrangements on who takes the final decision on Bank asset sales at times of difficulty in the gilt market. This should be the chancellor.
The Bank claims that following the pandemic its principal instrument for economic management is manipulation of interest rates, with the size of its asset sales unaffected by short-term developments. But there seems to be no explanation of how it chooses a particular objective for asset sales during a period of monetary tightening. While the hope may be that, once the current stock of assets is run down there will never be a return to QE, there is no guarantee that this will be the case in a world prone to economic and political crises. Therefore, the ground rules for QE/QT should be established.
How to coordinate fiscal and monetary policy
While coordinating fiscal and monetary policy is a virtual impossibility in the US and euro area due to constitutional arrangements, this is not the case in the UK. However, the relationship between the Treasury and Bank makes such coordination difficult.
The Bank’s principal objective is to control inflation through changes in interest rates. The Treasury has the potential to influence inflation through tax and spending decisions that affect aggregate demand as well as through specific policies such as changing taxes on expenditure and through subsidies (most recently to control energy prices). The review of macroeconomic policy arrangements should examine whether the control of inflation and aggregate demand could be more effective if the main monetary and fiscal policy decisions were taken together. If it concluded that this was possible the review should consider what institutional changes were necessary. The promise of informal coordination would not be a sufficient response.
UK policy-making has been unduly affected by changing fashions in macroeconomics. In the post-war period corrections in macroeconomic policy were primarily made through fiscal packages, with the use of interest rates thought unimportant by many in the Treasury and Bank. This odd approach was abruptly abandoned in 1979 with the Thatcher government, and many believed that only monetary policy should be used to control inflation and manage fluctuations in activity.
It is time to accept that both fiscal and monetary policy have a role in controlling the economy and institutional structures should be changed to reflect this. A review of macroeconomic policy-making should devise arrangements whereby the Treasury and Bank co-operate to control inflation and create the conditions for economic stability.
One option would be for the chancellor and bank governor twice yearly – in the budget and autumn statement – to assess what combination of fiscal and monetary policies is optimal, with the chancellor having the final say. If necessary, the Bank’s remit could be adjusted in the light of the intended fiscal policy decisions. The monthly decisions on interest rates would be taken by the Bank. New ground rules would be established for potential QE/QT. Decisions on the total of gilt sales, including QT, would be ultimately for the chancellor.
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 article will be published in OMFIF’s forthcoming Bulletin, which will focus on general elections happening around the world in 2024.