The 2001 film Ocean’s Eleven introduced the line “You had one job to do” into the popular lexicon. It is a charge that could be – and frequently is – levelled at the Bank of England (BoE) as inflation jumped to a 40-year high of 9 per cent in April.
While this view is an oversimplification, the recent surge in prices has nonetheless made life very uncomfortable for central banks around the world, as their inflation targets have been blown out of the water. Since they have taken a lot of credit for the quiescence of inflation over the past two decades, it is only right that questions are asked about what has gone wrong. Equally interesting questions are whether central banks really had much of a grip on inflation in the first place, and whether the current episode will result in changes to the conduct of monetary policy.
It is 25 years since chancellor Gordon Brown granted the BoE operational independence in the conduct of monetary policy. There was a growing academic consensus in the 1990s that monetary policy was too frequently used for political purposes, which made for sub-optimal decision making, and although politicians did want to reduce inflation they were not always prepared to take the tough decisions in order to make that happen. Accordingly, the BoE was given responsibility for maintaining the rate of RPIX inflation in a band centred around 2.5 per cent (plus or minus 1.5 percentage points), subsequently amended in 2003 to a target for CPI inflation of 2 per cent (plus or minus one percentage point). Since 1997 CPI inflation has averaged 2 per cent. Measured purely in terms of the target, the BoE appears to have fulfilled its mandate.
An inflation rate of 9 per cent in April represents almost six standard deviations from the post-1997 mean and has raised the suspicion in many people’s minds that the BoE must have got something badly wrong. The chair of the Treasury Committee, Mel Stride, put the suggestion to BoE governor Andrew Bailey that the central bank was “asleep at the wheel” while the Tory peer Michael Forsyth accused it of “unleashing inflation in our country through failing to meet its proper mandate.” Neither of these criticisms are fair, or indeed accurate. The BoE warned as long ago as last autumn that rising wholesale energy prices would feed through to impact CPI inflation in April 2022 and began to raise interest rates in December, well before the US Federal Reserve. Asleep at the wheel it was not.
Rebutting the criticisms
A moment’s pause for reflection should make us realise how ridiculous this position is. It takes up to two years for a tightening of monetary policy to impact on inflation. To have any impact on today’s inflation would have necessitated tightening monetary policy at the depths of the Covid-induced recession. It does not take much to imagine what the reaction of politicians would have been to such action. Instead, we should recognise that today’s inflation surge largely represents an exogenous shock over which the BoE has little control, being primarily the result of supply chain disruptions in the wake of the pandemic and rising energy prices following the Russian invasion of Ukraine. Indeed, energy accounted for 3.2 percentage points, or one-third, of inflation in April.
Nor has the BoE “unleashed inflation”. There were some in 2020 who believed that the supply side shock to the economy might eventually result in inflation, but this was very much a minority view, and in any case the collapse in output was always more likely to be disinflationary at first. Former BoE governor Mervyn King is one of those demonstrating the benefit of hindsight with his recent suggestion that quantitative easing (QE) was the wrong policy response to the pandemic. In his view, the collapse in output was the result of a government shutdown which impacted on the supply side. A policy of injecting liquidity into the economy to stimulate demand was thus inevitably going to lead to inflation as demand outstripped supply. He also suggested that the fiscal policy measures put in place by the government were sufficient to cope with an even bigger hit to the economy than in 2008. While this sounds plausible two years on, it is far from the whole story and does not accord with the view of events as they unfolded in real time.
In March 2020 when the BoE announced it would resume its QE programme, the initial £200bn expansion of the balance sheet was a response to adverse market conditions in which liquidity had all but dried up. A further £100bn of asset purchases announced in June 2020 was designed to support an economy which had taken the biggest hit of all industrialised economies, with output 23 per cent below pre-pandemic levels. Criticism of the BoE’s asset purchases in the first half of 2020 is thus misplaced. Even the final £150bn tranche, announced in November 2020, came at a time when the economy was about to experience an even more serious wave of Covid cases.
This is not to say that central banks have not made mistakes. Communications have been weak for one thing. In addition, the BoE could have called a halt to its asset purchase programme before the final tranche was exhausted rather than push for balance sheet expansion to the mandated £875bn. But by the time this was being contemplated the balance sheet was already so large that the impact would have been marginal at best.
How much control do central banks have?
A question which does not get sufficient airing in the debate is whether the economics profession really knows what drives inflation. After all, the forces underpinning it have been subject to various fads over the years. Between the 1950s and 1970s, attention focused on the labour market and the role of the wage bargaining process. During the 1980s monetary trends were the dominant paradigm, but over the last 25 years the main area of focus has been the degree of spare capacity and the role of inflationary expectations. Given the change in fashions over the years, it is difficult to take seriously the idea that there is a generic theory of inflation: like theories of the exchange rate, different factors drive the process at different times. If the cause is unknown, we thus cannot be sure what the appropriate cure is.
Policymakers tend not to be explicit about the monetary transmission process but former MPC member Adam Posen recently let the cat out of the bag when he suggested that the BoE “has no choice but to cause a recession […] it is duty bound to bring inflation down after more than a year when it has been more than two percentage points above its 2 per cent target level during a period of full employment.”
If the BoE was judged solely on the basis of its inflation record, he might have a point. But it isn’t, so he doesn’t. The Bank’s mandate is to “deliver price stability […] subject to […] the government's economic objectives including those for growth and employment”. A policy of deliberately triggering a recession in order to bring down inflation would fall foul of the conditionality clause. Moreover, attempts to reduce the degree of economic slack will do more harm than good if the current inflation surge merely represents a one-off spike in prices. Obviously, the BoE has to be seen to be acting to ensure that inflation expectations remain anchored, unlike in the 1970s. However, today’s economy is very different to that of 50 years ago when unions played a key role in driving up real wage growth. The prospect of a 1970s-style wage-price spiral today, reinforced by union militancy, is remote.
Reforming the framework
This has not stopped politicians from lobbing missiles in the BoE’s direction, with some on the government side of the House suggesting that the Bank’s independence should be curtailed. This would not represent an improvement. It would once again subject monetary policy to changes of political whim, and to the extent that the lags involved in its operation are not necessarily aligned with the needs of the political cycle, it is likely to cause more problems than it solves. However, there is a case for making some tweaks to the policy mandate. Space considerations preclude a more detailed look but one idea would be to follow the Fed and adopt a variable target in which inflation averages 2 per cent over time rather than constantly aiming to hit this rate. That would reduce the need to slam on the monetary brakes once inflation rises much above target.
Much of the criticism heaped on the BoE over recent months is misplaced. Earlier action would have done little to offset the worst of the inflation spike and significant future tightening is likely to raise the burden on an economy which looks set to flirt with recession. Some politicians may want to curb the BoE’s scope for independent action but that would be a mistake. Minor alterations to the framework, such as the adoption of long-term inflation targets, may be in order, but we should be careful not to throw out the baby with the bathwater.