We need to talk about the Bank of England

Good morning from New Economy Brief.

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Whichever party emerges victorious in the election next week, the next government’s relationship with the Bank of England (BoE) is going to be very important.

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We are emerging from the first major inflation crisis since the BoE became independent in 1997, and it is reasonable to ask what lessons we can learn from how it responded to this shock and whether its decisions have an outsized impact on the fiscal space and political programme of the next government.

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The last time Labour took power in 1997, then-Chancellor Gordon Brown unexpectedly gave the BoE its independence and ended a decades-old tradition of the government controlling interest rates. This idea did not feature in Labour’s 1997 election manifesto; could Rachel Reeves, a former economist at the BoE, pull another rabbit out of the hat and announce a surprise monetary policy reform?

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This edition of New Economy Brief explores the case for changing the UK’s macroeconomic framework and highlights some forward-thinking proposals for a new monetary policy regime.   

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The economic and political case for monetary policy reform.

Since 2022 when the UK economy suffered a supply-side energy price shock, the path taken by interest rates has been central to political discourse and a key measure of whether the Conservative government’s economic strategy is working. In short, the strategy was to limit the worst effects of higher energy bills through the Energy Price Guarantee and limit as much government spending as politically possible to avoid injecting further inflationary pressure into the economy, in the hope that the BoE’s Monetary Policy Committee would eventually start to cut interest rates before the general election. Inflation has now reached the 2% target, but rates are still at the highest levels seen since 2008 (5.25%), with the Bank once again refusing to cut them last week. 

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The problem with relying on interest rates to limit supply-side inflation. The idea behind increasing interest rates is to raise the cost of borrowing in the economy and so limit spending and investment (for example, through homeowners facing higher mortgage payments and so having less disposable income). This will inevitably reduce economic growth and have a variety of harmful effects on public debt, mortgages and the housing market, international debt repayments, business lending, unemployment and financial stability. Many economists see this as a misguided act of economic self-harm when inflationary pressures come from supply shocks rather than ‘overheated demand’. (And by some accounts this is true most of the time – IMF chief economist Pierre-Olivier Gourinchas and co-authors recently concurred that “the international rise and fall of inflation since 2020 largely reflected the direct and pass-through effects of headline shocks.”)

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Higher inflation will return. Many economists also think higher inflation is the new norm in the anthropocene, given the likelihood of further supply-side shocks driven by climate change and geopolitical instability (e.g. drought, wildfires, poor harvests, trade disruptions and resource wars). If this is true – and there are many reasons to believe it is – then under the UK’s current macroeconomic architecture, the BoE is likely to continue raising interest rates, choking economic growth, and limiting the next government’s borrowing freedom, spending power and, ultimately, political success. So the BoE’s current price stability mandate could become a political problem, and the persistent threat of inflation will probably continue to strengthen the case for the next government reforming it.

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Anti-inflationary policy for an unstable global economy.

“Voters are right to point the finger at governments, who do have a role in ensuring no repeat of the “shockflation” that has rocked economies this decade”, writes the Times’ Mehreen Kahn this week. What else then could governments do to limit supply-side inflation? Isabella Weber, an economist at the University of Massachusetts, proposed that governments should stress-test industries that could unleash inflation spikes, just as they do with too-big-to-fail banks. She identified eight strategically important sectors which drove the second-round effects of inflation after the pandemic and invasion of Ukraine, and argued that a wider range of policy tools is needed to prevent sticky inflation and price gouging.

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The state’s new role in preventing ‘shockflation’. Weber and Jens van ‘t Klooster called on the European Union to embrace anti-inflation measures like price controls and creating price buffer stocks of essentials for human life (e.g. food, housing and utilities), industrial production (energy and chemicals) and commerce (e.g. wholesale trade and transportation) in strategic sectors, to protect against supply shocks. Alongside more monitoring of prices in the economy and more active competition policy to ensure consumers are not at the sharp end of corporate price gouging, this could stop inflation spreading from the initially affected sector into others. (For a case study on how unconventional fiscal policies can limit pass-through inflation – policies like insulating essentials from the rising cost of living with price controls – read our previous explainer on how the Spanish government has responded to their cost of living crisis.)

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Reforming the UK’s monetary policy regime.

The eventual decision on when to cut interest rates, and by how much, will have huge fiscal implications for the next government, mainly by reducing government borrowing costs and freeing up space for more spending without breaching the current fiscal rules. But this isn’t the only decision the Bank will take that will impact the government. Arguably just as significant is the decision on how far to go with the Bank’s Quantitative Tightening (QT) programme of selling off government bonds. QT matters enormously to the Treasury (we covered it in a recent explainer). Potential new Chancellor Rachel Reeves has been keen to emphasise her respect for the BoE’s independence as part of a stable set of macroeconomic institutions, but given how deeply decisions around QT could constrain its freedom to manage the economy, the government will naturally be extremely interested in these decisions, and potentially in reforming the framework within which they are made. 

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What’s the mandate? During the pandemic, the BoE implicitly began monetary financing to create fiscal space to finance pandemic-related support measures, such as furlough and healthcare investment. This alignment between monetary and fiscal policy proved useful in coping with emergency, but it was never formally acknowledged. The next government will have some policy tools available to stop contractionary monetary policy eroding its spending power – perhaps saving way over £100bn. These could include paying less interest on government debt issued as part of quantitative easing and held by commercial banks and slowing down quantitative tightening to prevent losses for the taxpayer. Nevertheless, the BoE may need an updated mandate that lets it coordinate with the next government’s fiscal goals. Different arrangements have been proposed that would respect the principles of central bank independence while also helping monetary and fiscal policy work in tandem, rather than against each other:

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Green credit guidance. Given that raising interest rates is likely to slow the green transition by increasing borrowing costs, this could be the time to revisit credit guidance policies. The BoE can work with other government agencies to restrict borrowing to invest in unsustainable activities (such as fossil fuel extraction and destruction of key ecosystems), while supporting lending for green energy, housing, and infrastructure. The New Economics Foundation’s proposed that the UK could do this by repurposing the BoE’s Term Funding Scheme – which currently provides cheaper credit to businesses and households – to instead encourage banks to lend more for investments in sustainable projects, so that these projects could borrow more cheaply. (Read our previous New Economy Brief for more on Green Credit Guidance)

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Moving beyond 2% inflation targets. Economists Jo Michell and Jan Toporowski argue that the BoE should be given an enhanced financial stability mandate that makes it coordinate more explicitly with the Treasury, “but need not eliminate the independence of the Bank”. They review a variety of proposals for reforming monetary policy (Page 23-29) including replacing the BoE’s inflation targeting with a growth target,  concluding that “the proper regulation of employment and investment in the economy is a matter of policy for Government, not the central bank.”

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‍Monetary and fiscal coordination. Peter Sedgwick of the Official Monetary and Financial Institutions Forum suggests that whoever wins the next general election, “it will be time to review the institutional arrangements for monetary and fiscal policy”. A pamphlet from the Fabian Society has proposed “a new economic policy coordinating committee should be set up to bring together the Treasury, the business department and the Bank of England, alongside the devolved governments and arms-length bodies responsible for climate change, public finance, infrastructure and low pay” to share analysis and coordinate policy to manage the economy more effectively.