The general consensus on how best to run the monetary side of an economy has been to have an autonomous central bank – an entity with sole responsibility for controlling inflation and using standard monetary policy tools.
However, in the UK, and following the high inflation of 2021-23, it is now time to reexamine the arguments for the Bank of England’s independence nearly 30 years after Prime Minister Tony Blair and Chancellor of the Exchequer Gordon Brown set up the Monetary Policy Committee in 1997.
I favour making the UK’s management of inflation in 2021-23 the subject of a full public inquiry. An investigation should build on the largely technical findings of the 2024 review conducted by former US Federal Reserve chairman Ben Bernanke. In addition, the House of Commons Treasury Committee reported on quantitative easing in 2024 and the House of Lords Economic Affairs Committee completed a separate inquiry on independence in 2023.
Such a review should extend beyond the operation of the Bank in isolation. It should consider the Bank’s place in national economic policy conduct and examine its interaction with the Treasury. The aim should be to redesign and strengthen the Bank’s political oversight as well as its public accountability.
Social and political pressures
After a period of high inflation, we should examine afresh some key questions. Should the role of central banks be narrowly defined and treated as ‘merely technical’? Should their actions be isolated from the rest of national economic management? Should their governance continue to be at arm’s length to the political process?
The standard defence of keeping central banks at one remove from the political process is powerfully entrenched. As central bankers are keen to point out, the period of widespread central bank independence neatly coincided with the period of low inflation of the 2000s and 2010s. But the thesis can be challenged.
The idea that monetary policy is too important to entrust to politicians – because they have short horizons driven by the electoral cycle – begs a question. What makes decisions on interest rates so unusual? What should we do with real life-and-death decisions, such as the declaration of war? Should they too be considered too important to entrust to politicians?
The suggestion that monetary policy is merely a technical matter without political or social consequences cannot be maintained either. Changing interest rates creates winners and losers in society just as much as any move the chancellor might make in the budget. The extended period of ultra-low interest rates up to late 2021 favoured asset-owners and existing homeowners. And the very sharp increase in interest rates since then has wrought havoc with the finances of many borrowers, most obviously, young families seeking to buy a home.
Tighter co-ordination between central bank and finance ministries
The clinching defence is that low inflation for 20 years proves that central bank independence works. The problem with this defence is that it collapses completely the moment it ceases working – which many would say that in 2021, it did.
Managing the monetary side of an economy is important. But this makes it even more crucial that it should be an integral part of an economy’s management, particularly in co-ordination with other actors.
In practice, central banks cannot ignore what finance ministries do. They often find themselves responding to finance ministry policies and decisions in an effort to restore stability after the politicians have done their worst, such as September 2022’s ill-fated UK budget.
A far better solution would be for central bank and finance ministries to work together, planning fiscal and monetary policy as a coherent whole. This is surely likely to prove more successful than working without reference to each other, sometimes pulling in opposite directions.
The advent of QE makes the idea untenable that monetary policy is a ‘technical matter’. In the UK, extensive QE has radically changed the size, tenor and interest cost of the national debt, as well as the distribution of winners and losers. All of these factors are political, not merely technical and they impact directly on the Treasury and its fiscal management.
We can justifiably query how much central banks really understand inflation at all. The long period of low inflation from the mid-1990s to 2020 is open to various interpretations. Were central banks responsible? Did they create the low inflation or did they merely preside over it? How much was due to external factors such as the end of the cold war, the increase in globalisation, new technologies and above all, China’s entry into the world economy?
Central banks tried for 10 years between 2010-20 to increase inflation with almost no success – but at huge cost. If they could not increase inflation when they wanted to, why are they credited with the power to decrease it?
Furthermore, central banks spent much of 2021 and 2022 saying they were not responsible for the then-high inflation. ‘Not a monetary phenomenon’, they said, and with some justification – though they proceeded to use monetary methods to attack it. We know why this is: working in isolation of other organs of government means monetary methods are all they have at their disposal. But would it not have made more sense to work with their respective finance ministries on an all-economy response, when the full range of policy tools could be considered and deployed?
Absence of an alternative?
The final issue to resolve is the question of democratic accountability. How can a democracy align commonly accepted societal objectives – stable prices – with oversight through the electoral process and the actions of an unelected agency? And, more directly, how does the electorate express its views and concerns over central bank policy?
Let us go back to those young families whose finances were upended by the rise in interest rates and mortgage rates in 2022 and 2023. What is their political remedy? How do they express an electoral preference for an alternative approach? It is not good enough for central banks to say, in effect, ‘There is no alternative. You must just accept what we decide.’
All of these questions go to the heart of the decision to free monetary policy from the hand of government. The ability to subject generally accepted theses to rigorous questioning is the hallmark of democratic societies. It is time for a reappraisal of the system, in the hope that we can find better answers to crises that, sooner or later, are bound to reappear.
John Nugée is a Senior Adviser to OMFIF and former Chief Manager of Reserves at the Bank of England.
Image credit: Geoff Henson
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