BoE faces its biggest inflation challenge since independence

Immediately after wrapping up his first monthly monetary policy meeting as Chancellor and raising interest rates a quarter point to 6.25%, Gordon Brown dropped a bombshell. The new Labor government’s first monetary policy meeting with Bank of England Governor Eddie George was also set to be its last.

From then on, May 6, 1997, the BoE would be independent in setting interest rates through its newly created Monetary Policy Committee. Now, 25 years later, central bank independence has not been seriously challenged under five prime ministers and six chancellors of the exchequer.

“It’s amazing how [BoE] independence is now part of [UK’s] institutional furniture,” Ed Balls, then Brown’s adviser and architect of the plan, told the FT

But with UK prices likely to rise at their fastest pace in over 40 years, as sustained double-digit inflation becomes possible for the first time since the 1970s, former officials and economists say the An independent BoE faces challenges it hasn’t encountered in the past quarter of a century.

Labor Chancellor Gordon Brown, left, with Bank of England Governor Eddie George in 1998. © Gerry Penny/EPA

These include preventing inflation from spiraling out of control; avoiding distraction by fashionable ambitions, such as tackling climate change and inequality; ensuring transparent political debate; and maintain the legitimacy of its unelected officials to take the necessary measures to defend the stability of the financial system.

Lord King, governor between 2003 and 2013, insisted that the process of granting the central bank greater autonomy in the early 1990s to full independence to set interest rates in 1997, has was a success and allowed the BoE “to have an independent voice and one for which it was responsible”.

The history of the central bank after independence is divided into two main periods. The first decade was one of apparent triumph, with financial markets reassured that New Labor would not be lavish with public money and generate inflation.

Line graph showing The quarter century since independence from the BoE is divided into two parts

Government borrowing costs fell, giving Brown more room to increase social welfare spending and other priorities, while economic growth was strong and inflation remained within 1 percentage point of the BoE’s inflation target.

Such was the strength of the economy that Brown regularly boasted that he was not going back to “boom and bust”. On the 10th anniversary of independence in 2007, King said, “It is not, I believe, credible to reject [the good economic performance] only by luck”.

However, the good times did not last. Economic growth per capita, which averaged 2.2% per year in the UK during the first decade of independence from the BoE, has fallen to just 0.4% per year on average since.

The economy suffered huge recessions following the global financial crisis of 2008-09 and the coronavirus crisis in 2020, which sandwiched years of crushing austerity as the UK faced to be poorer than everyone expected. Now he is facing a fourth shock following Russia’s invasion of Ukraine, which is pushing inflation up and creating a cost of living crisis.

Inflation has been much more volatile than in the first decade, briefly exceeding 5% in 2008 and 2011 and threatening deflation after 2014 before climbing to 7% in March this year. Price increases are now heading towards double-digit rates not seen since the oil shocks of the 1970s.

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Mark Carney, governor between 2013 and 2020, said uncertainties about the extent of the drop in productivity growth – and whether it was permanent – ​​made monetary policy much more difficult to manage.

“The extent [productivity growth] left was an open question. . . then we had a potential supply shock due to the Brexit decision which was relevant for monetary policy over our forecast horizon,” he said.

Over the full 25 years, however, inflation’s record is good, according to Jagjit Chadha, director of the National Institute of Economic and Social Research. “However you measure it, [MPC members have] achieved their inflation target and that needs to be reiterated among all the critics – it tells us something about the value of having experts involved,” he said.

King described the UK’s economic performance in the 10 years to 2003 as the “beautiful decade”, which he said was a warning that the good times could not last. “If we hadn’t had independence, there would still have been a global financial crisis,” he told the FT.

October 2008 — the global financial crash.

October 2008 — the global financial crash. © Ray Tang/Shutterstock

But the central bank has faced serious criticism in the wake of the crisis. George Osborne, chancellor between 2010 and 2016, believed that the inability of the British authorities to adequately supervise its financial system before 2007 required the BoE to have more power to regulate banks and the financial system, and a new governor, Carney, no marred by the crash.

With poor economic performance, accusations of interest rate flip-flops and allegations of politicization in the Scottish and Brexit referendums, BoE scrutiny has only increased in recent years.

But it is Andrew Bailey, the governor since 2020, who faces the toughest task of steering the central bank through a period of renewed inflation, according to former officials and outside analysts.

After the Lords Economic Affairs Committee last year accused the BoE of having a ‘dangerous addiction’ to quantitative easing and of increasing spending whenever the going gets tough, the central bank must decide to how quickly to withdraw stimulus measures to contain inflation.

“I think it’s a great time for [central banks] because they really have to demonstrate that they are committed to restoring price stability,” King said. “It’s too late to say we have a few months of high inflation and it will go away – it’s more a matter of a few years,” the former governor said.

Line chart of CPI inflation and successive BoE forecasts, 2021-22 (%) showing that the Bank did not expect to have to fight double-digit inflation

Adam Posen, chairman of the Peterson Institute for International Economics and former MPC fellow, believes the BoE has no choice but to raise interest rates even if it triggers a recession at a time when household incomes are squeezed by rising energy prices.

“If the real income [declines] drives inflation cycles, we wouldn’t need monetary policy,” he said. “The reason you need a monetary policy-induced recession – probably needed in the UK – is that the effect on real income does not reduce inflation unless and until conditions of the labor market are improving.”

Pedestrians walk past the Bank of England during the first Covid lockdown of March 2020.

Pedestrians walk past the Bank of England during the first Covid lockdown of March 2020. © Matt Dunham/AP

Paul Tucker, former deputy governor and author of Unelected powera book that questions whether central banks have been given too broad a mandate, believes the BoE can meet the challenge of higher inflation if it sticks to its primary objective.

“Independence was a success, which was not wiped out by the global financial crisis,” he said. “But the BoE now needs to focus on controlling inflation and stability of the broader banking system and that’s it.”

But there are concerns that the BoE may be reluctant to hold the same open and public debate on tough economic issues as when it became independent, which could undermine public confidence that its independent officials will address tough policy choices. a way that politicians would avoid.

When inflation heads into the double digits, Chadha said, “the MPC is much too quiet” to talk about big issues in public. Balls agreed that “over time, the [monetary policy] the debate has become more discreet” and that it would be beneficial for the public to see the differences between the experts aired in public.

But as the independent central bank celebrates its 25th anniversary, there are almost no calls for the government to regain control and few believe politicians would risk suppressing independence.

“You can never take anything for granted,” Carney said. “But I think the structure of the MPC – enshrined in legislation, with explicit processes and personal accountability – significantly reduces that risk.”

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