Some comments on “Making an independent Bank of England work better”
Malcolm Sawyer
Emeritus Professor of Economics
University of Leeds, UK, and FMM Fellow
Monetary Policy Institute Blog #126
This blog was written in reply to Economic Affairs Committee 1st Report of Session 2023–24 HL Paper 10 by the British House of Lords (link to report here)
“The Committee appears concerned over a lack of diversity of thought and perspective but without challenging the dominance of a mainstream economics paradigm and the dominance of monetary and financial interests in the operation of monetary policy.”
“Making an Independent Bank of England Work Better” is a report from a committee of the UK House of Lords (November, 2023), which marks the 25th anniversary of the operational independence of the Bank of England, and as such is seen as an appropriate time to review the operation of that framework with respect to the conduct of monetary policy.
The Committee believes that “the enhanced credibility of monetary policy brought about by independence has contributed to a low inflation environment. The absence of political interference is seen by many as a major component of stable inflation expectations.” What is termed here as ‘political interference’ is more akin to a ‘democratic deficit’ in which views of elected government are ignored. The Committee holds that “independence should be preserved”: independence here is in the form of independence from government in the setting of interest rates, and there is no consideration of what forces and what ideas the Bank of England is dependent on.
This report never questions the idea the Bank of England should be independent (of government), but rather, at places, even bemoans threats of compromise of that independence, e.g. through co-ordination of monetary and fiscal policy, results of Quantitative Easing. The Committee finds that “this widening of the Bank’s remit risks jeopardising the Bank’s ability to prioritise its primary objectives; risks drawing the Bank into the Government’s wider policy agenda; and increases the potential for conflict between its objectives.”
They recommend that the Bank of England remits “should be pruned by HM Treasury”. While it may be agreed that policies of a central bank are not central for addressing inequality and climate change, aspects of monetary policy do have implications for inequality and climate change. It may be difficult to know how consideration of inequality could be brought into interest rate decision making, but it has to be recognized that interest rate decisions have income distribution impacts and on wealth distribution via effects on asset prices.
Climate change, however, presents some different issues. Suggestions have been made that ‘green’ considerations could be built into the operation of quantitative easing (though a policy which is now unwinding). It is widely recognized that transition and climate change have some significance for financial risks, and that the Bank of England be charged with financial stability.
The Committee argues that although the precise contribution of central bank independence to low inflation is difficult to quantify, it believes that “the conditions established by independence have provided a strong foundation for low and stable inflation since 1997.” It does not elaborate on how the conditions were established, nor does the Report acknowledge the empirical findings of many, including some central banks, that varying rates of interest have rather little effect on the rate of inflation. The experience of the last two years has emphasised again the importance of global inflation for national inflation, though admittedly the Report does mention the possible role of globalisation is restraining domestic inflation.
The Committee expresses their concern “that a democratic deficit has emerged, which risks undermining confidence in the Bank and its operational independence.” They recommend enhanced parliamentary scrutiny in light of the expansion of the Bank of England’s remit. A ‘democratic deficit’ lies at the heart of the push for independence of central banks and the adoption of inflation targetting. Interest rate decisions are placed in the hands of central bankers because they will make different decisions than elected politicians would. The ‘conservative central banker’ argument came down to the argument that bankers would pay more regard to reducing inflation than to lowering unemployment. The committee argues that because “the Government is unable to challenge the Bank’s decisions without compromising its independence”, there is an inevitable democratic deficit.
The committee states that “in 2021 the Bank of England, like many central banks, incorrectly forecast that above-target inflation would be ‘transitory’. This was in part thanks to a lack of challenge as regards its modelling and forecasts.” It can be argued that as inflation rates fall, inflation has indeed been transitory. The UK rate has now dropped to 4 per cent, albeit still above the inflation target. I do wonder that if the Bank of England had done nothing with interest rates the path of inflation would have been any different (though in face of other central banks raising interest rates it would have been difficult to sustain).
The failures of the Bank of England with regard to responding to higher inflation is a combination of a number of factors. The Bank found it difficult to recognize the dominant supply-side shocks associated with disruptions to gas and oil supplies and rising food prices, associated with the Russian invasion of Ukraine. The Bank did not consider the rise in profits, whether as a cause or a consequence of inflation. The appropriate way of tackling this surge in inflation was not through raising interest rates, which would have little effect in containing inflation (as this blog has repeatedly argued). Policies of price controls, strategic use of subsidies and income support were required but, of course, these fall outside the remit of central banks. Raising interest rates were used more to raise unemployment and limit wage increases after the major price rises had occurred. There was in effect little a central bank could do that would have lowered inflation. Interest rates have limited effects on inflation — work by central banks has found a 1 per cent higher interest rate may lower inflation by ¼ per cent over period of up to 18 months. The bank rate was raised by 5 percentage points over 18 months, but that would not by itself lead to the fall in inflation observed. In effect, the raising of interest rates was aimed at restraining wage increases rather than price increases.
Chapter 4 of the report is entitled “diversity of thought and culture”. The report ascribes errors made “in the conduct of monetary policy by the wider central banking community, including the Bank of England to lack of diversity and a culture which discourages challenge.
There are many aspects to diversity, particularly of perspective. The membership of the committee (which includes ex-governor of Bank of England, Lord Mervyn King) does not strike me as diverse in terms of those with a more critical perspective on the financial system. Similar remarks can be made on those who gave evidence to the Committee. The Monetary Policy Committee (of the Bank of England) who make the interest rate decisions are similarly drawn from a narrow circle. Four members of the MPC are external appointees, while the remaining five include the Governor, three Deputy Governors and the Chief Economist of the Bank. A number of the internal appointees have previous links with HM Treasury, who also make the external appointments.
The Committee argues that “every member of the MPC must be committed to fulfilling the Committee’s objectives” which makes it difficult to appoint people who believe that the Bank of England’s objectives should include employment etc.. It also makes it difficult to appoint people who doubt that interest rates have much effect on inflation. The Committee then argue that “it is imperative that its membership comprises people of different backgrounds and economic perspectives”. This would require appointing economists from the outside the mainstream who take a different perspective on the stability of the economy, the inflation generating processes, and who have no truck with DSGE models and the like. But it also requires the appointment of economists from outside those with narrow monetary macroeconomic background including labour economist, industrial economists etc. Even more, it requires people with ‘real world’ experiences including industrialists and trade unionists, for instance.
The surrounding discussion on lack of diversity appears to view this lack of intellectual diversity in terms of “absence of any detailed discussions about money supply” in the Monetary Policy Reports. The committee then advocates that Monetary Policy Reports include discussion of the main monetary aggregates, pushing in the direction of a monetarist approach to inflation. There is no consideration of the conditions under which loans are being created and the possible causes of the creation of loans and thereby rise of bank deposits.
The Committee argues that the review on the Bank of England’s forecasting headed by Bernanke should “explain the value of models that seldom predict anything other than a return to the two per cent target over their forecast horizon”. It is, of course, an inevitable feature of models that tie inflation to expected inflation, and then tie expected inflation to the target rate of inflation. It is another reflection of the lack of diversity and dominance of a particular mind-set.
In conclusion, the thrust of the report came across to me as the independence of the central bank must be defended and enhanced. This appears largely based on a perceived success of inflation targeting on which I would cast doubt. The Committee appears concerned over a lack of diversity of thought and perspective but without challenging the dominance of a mainstream economics paradigm and the dominance of monetary and financial interests in the operation of monetary policy. A more critical perspective on central bank independence is required!
