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OPINION

Is the Bank of England fit for purpose?

Is the Bank of England fit for purpose?
August 30, 2022
Is the Bank of England fit for purpose?

The Bank of England (BoE) is in hot water: at 10.1 per cent, inflation is soaring past its 2 per cent target. Business and energy secretary Kwasi Kwarteng was far from alone in concluding earlier last month that “something has clearly gone wrong”. Attorney general Suella Braverman was similarly unimpressed, arguing that the government needs to look at whether the BoE is “fit for purpose”.

The BoE has been no stranger to criticism over the past 12 months. But now one of its most vocal critics might soon be prime minister. Liz Truss told an event in Cardiff that she wants “to change the Bank of England’s mandate to make sure in future it matches some of the most effective central banks in the world at controlling inflation”. She added that “the last time the mandate was looked at was in 1997 under Gordon Brown. Things are very, very different now”. With the Conservative party leadership election due to conclude on 5 September, and with fellow critics Kwarteng and Braverman likely to play a key role in a Truss cabinet, these reproofs come at a crucial moment.

The BoE sets monetary policy to achieve the government’s target of keeping inflation to 2 per cent. But it is also expected to hold a wider focus, balancing its target of stable inflation with “supporting economic growth and jobs”. 

By any measure, the Bank's performance looks disappointing. Its own forecasts project that inflation will remain above 9.5 per cent for the next 12 months. It also expects an accompanying five-quarter recession, and unemployment of up to 6.25 per cent, in the absence of any fiscal policy changes. The BoE will soon be forced to tread a fine line between supporting growth and squashing expectations of future inflation. In the near term, it is odds-on to increase interest rates again in the months ahead – even as the economy begins to contract. 

 

Too little, too late?

The key criticism levelled at the BoE is that it was too slow to act against the threat of rising inflation. As the charts show, inflation first pushed above target in August 2021. But the Bank only began initiating a series of (gradual) rate hikes in December. 

The BoE governor, Andrew Bailey, objects. He argued on the Radio 4 Today Programme on 5 August that “what has happened is that there has been a series of very big supply side shocks, most of which are coming from outside”, and added that the “vast majority” of inflation was externally driven. This is not untrue: inflation is expected to hit at 13 per cent later this year, and energy prices alone will account for half of this.

But this doesn't mean the central bank is off the hook. Economists at Berenberg are particularly critical of its failure to act decisively to dampen inflation expectations. They argue that “had the BoE started to tighten even six months earlier, inflation expectations would have remained better anchored and policymakers would now be much less worried about the second-round inflation effects emanating from the Russian war and renewed Chinese lockdowns”. Yet the BoE was a relatively ‘early riser’, hiking rates before the US or eurozone, as the second chart shows. 

The BoE faces more convincing condemnation for failing to roll back quantitative easing after financial conditions eased. Economists at Panmure Gordon agree that there is “some merit to this criticism”, but find that it may have made surprisingly little difference in practice. Their modelling suggests even if quantitative easing had stopped in the first half of 2021 and rate rises started a quarter earlier, UK inflation would still peak at 11.5 per cent this year – only slightly better than today’s 13 per cent forecast.

Central bank messaging has also faced censure. Bailey, a poor communicator, has come under fire for badly-received comments about the need for a “painful” moderation of wage rises and for use of the term "apocalyptic" to describe his take on food prices.

The BoE is also guilty of information overload. Following the last MPC meeting, Berenberg’s senior economist, Kallum Pickering, argued that “by publishing several alternative forecasts…the BoE continues to drown out its key message with excessive noise”. August’s monetary policy report was 101 pages long. 

Berenberg economists also believe that “unless the BoE opts for a leaner and more pointed communication strategy, financial and economic actors will continue to struggle to understand [its] reaction function or predict what the bank may do next”. This is a significant problem. If muddled communication means that expectations about the future rate of inflation stay high, the central bank will find it increasingly difficult to get inflation back down to target. 

 

Reforming the Bank?

It is no surprise that the BoE is facing scrutiny. But is a significant change to monetary policy operation really on the horizon? Suella Braverman told Sky News in August that Truss would look at whether the BoE was “fit for purpose in terms of its entire exclusionary independence over interest rates”, which prompted Truss’s core team to swiftly insist that the BoE’s independence was safe. 

More likely is a move to give Parliament increased oversight. The BoE has independence in terms of how it carries out its responsibilities, yet interacts frequently with the government: the governor writes an explanatory letter to the chancellor each time the inflation target is missed, and the government both sets the Bank’s remit and appoints its senior policymakers. There are few indications of the form that enhanced oversight might take, but increasing the influence of the Treasury Committee is a possible route: it already has the power to question BoE officials about the state of the economy and review candidates appointed to serve at the central bank. The new chancellor may also pen a more gutsy response to the governor's explanatory letters. 

We may even find that the inflation target is replaced with an alternative metric – money supply and nominal GDP have both been mooted. But the case isn’t overwhelmingly convincing: Capital Economics’s senior UK economist, Ruth Gregory, says this is "unlikely to be a sort of magic solution”, and argues that there isn’t any reason to think that the BoE would be any more successful in hitting a nominal GDP target than it has been at hitting the inflation target in recent months.  

Another option could be to tighten the inflation target, perhaps by removing the requirement for the BoE to support growth and employment. Yet by international standards, it is already relatively single-minded: the Federal Reserve, for example, is obliged to wrestle a ‘dual mandate’ of maximum employment and price stability.  

 

Losing interest 

But we may find that enthusiasm for central bank reform peters out. Any significant changes would likely begin with a lengthy review (Australia's central bank is currently undergoing something similar). The ECB’s recent 18-month long strategy review is an example of how long this process can take. 

And 18 months is a very long time in politics. Will the government start to lose interest? Economists at Panmure Gordon argue that some of the BoE's strongest detractors are “the political critics who are largely looking to redistribute some of the ire from voters that they will inevitably face this winter”. Berenberg’s Pickering also senses a degree of political expediency, believing that current criticism is “probably a tactic by Truss to demonstrate that she is an inflation hawk, despite her plans to pursue inflationary tax cuts”. Panmure Gordon says these critics tend to be long on problems and short on alternative policy paths – or credible ideas for a mandate change. 

Compounding this is the fact that forecasts still imply that inflation is, in the context of structural reform timelines, a temporary problem – expected to return back to target in two years’ time. This means that by the time any review concludes, eye-watering inflation rates may well be a thing of the past. 

This doesn’t mean that the BoE should escape scrutiny. The last five years have seen the UK economy shoulder the impacts of Brexit, the coronavirus pandemic and soaring energy prices. At the very least, firms and households need reassurance that the central bank fully understands today’s inflationary landscape, and that it is well prepared to deal with the UK’s next economic shock.