Liz Truss, favorite to become Prime Minister of the United Kingdom on September 6, advocates a review of the independence of the Bank of England at a time when the pound is already under pressure. High inflation, still loose monetary policy (the real discount rate is below minus 8%), a growing current account deficit and high debt mean the pound has always been a likely looser way to bolster risk policy and pursue fiscal expansion.
OMFIF estimates suggest that since 2000, based on real and cyclically-adjusted fiscal changes, the UK has made more net easing in macroeconomic policy than any other major country. And, given the inflation premium, it is hardly a coincidence that the pound underperformed over the period on fundamental considerations (chart 1).
Figure 1: The UK’s loose policy mix helps explain the relative weakness of the pound
Trade-weighted exchange rates, rebased on Q1 2000 (=100)
Source: Refinitiv data feed
This is a weak platform on which to base uncertainty about the future of the Bank. Truss’ intentions are unclear, and his suggestion so far to conduct a “mandate review” may prove innocuous. It would be beneficial if the review avoided some of the mistakes of the past and assisted the Monetary Policy Committee in an orderly monetary normalization. As one of Truss’ supporters rightly points outa major underlying macro-economic problem has been “the adverse consequences of low to negative interest rates over a prolonged period” (Lord David Frost, former chief UK negotiator for leaving the European Union).
More sinister, especially for the pound and the longtime gilts, would be followed by some of the instincts of its other backers. These include Suella Braverman, the current attorney general, touted as an interior secretary at a Truss firm, who is keen to monitor whether the Bank is ‘suitable for its purpose in terms of its complete independence of exclusion from interest rates‘.
Watering down independence would be counterproductive. It would be a throwback to the “Ken and Eddie show” of 1993-97 where the Chancellor and Governor of the BoE set rates, advised by the Treasury’s panel of “wise men”. This direct government contribution to rate setting sometimes smacks of election cycles. Such open intervention would go against the practice of other G7 central banks, requiring an international risk premium on UK money market rates and, costly for the Treasury, gilt yields.
And if it increases inflation further, it will have unintended consequences. The BoE’s economic model assumes that it takes four years for higher import prices to be fully passed through to a basket of consumer price indices of which one-third is imported. This shortfall, still apparent after the last weakness in the pound, has largely been absorbed by profit margins. Related to this, real wages are deflating again – after stagnating for a decade for the first time since the 1860s (Chart 2). Removing independence is not the obvious route to wage growth in the private sector.
Still, a review of the MPC after its first 25 years seems eminently sensible and can be constructive. This would be akin to the Reserve Bank of Australia’s ongoing one, which is expected to wrap up in the new year. Among the MPC’s victories is CPI inflation since 1997, which has averaged close to the medium-term target of 2% yoy. The challenge now is to get it back on target from the at least 13% expected in the coming months and to embrace quantitative tightening without extending the recession beyond 2023.
This and the political heat directed at him are two reasons why Bank of England Governor Andrew Bailey is now making up for lost time. The independence of the Bank has in any case become blurred since 2009, its operations blurring the boundary between monetary policy and budgetary policy.
Figure 2: Another decade of sub-par wage growth?
UK unemployment rate (%) versus profit margins and real income growth. Blocks denote recession in UK
Source: Refinitiv data feed
So how could the arrangements be changed? One possibility could be a midway house to resurrect some form of ‘wise’ panel to supplement the MPC. This would allow for independent input into the Bank’s decision-making process and could be attractive to some of Truss’ advisers. Patrick Minford, professor of applied economics at Cardiff University, was a member of the panel in the mid-1990s and never afraid to stand up to his peers and side with the government on tax cuts.
But it would also suggest distrust of the abilities of current MPC members to handle monetary affairs. Would resignations from the MPC follow? Performance could be assessed in a less controversial way simply by strengthening or making existing Treasury Special Committee surveys more frequent.
If the mandate were to change, options could include expanding or reconfiguring the current CPI focus. This could mean raising it to 3% year-on-year to allow the economy to breathe while fighting future inflation and/or making it symmetric by setting a floor for any risk of future deflation. In the current inflationary climate, however, this would send the wrong signal to financial markets.
It might be better to impose an inflation target that is more indicative of the cost of living which helps wage negotiators. MP Sir John Redwood, director of political unit number 10 under Margaret Thatcher and tipped for a return to cabinet under Truss, complains that the targeting of the (relatively narrow) CPI has led to an artificially low discount rate . There’s some truth to that as real estate prices and local taxes rise.
The simplest option might be to switch from CPI to CPI(H). This would improve on the former by simulating house price changes, albeit via the original owner-occupier housing cost method. Another is to revert to the retail price index minus mortgage interest payments, which the MPC was aiming for at 2.5% yoy before Chancellor Gordon Brown switched to the CPI in December 2003. This includes accommodation prices and local taxes. But, with the RPI expected to be aligned with the CPI(H) by 2030, it makes logistical sense to target the latter.
To better distinguish demand from cost inflation, it may then be preferable to link a credible activity indicator to the chosen inflation target. Since 1977, the dual mandate of the Federal Open Market Committee covers price stability, via the underlying inflation of personal consumption expenditure, and the maximization of employment. Including employment can be trickier for the BoE, given that its economic model has sometimes struggled to predict it. This caused the failure of the foresight in 2013 and Bailey’s admission when furloughed in 2020 that “labor data…is the most difficult to interpret”. The relatively flat Phillips curve was one of the factors that delayed rate hikes.
Alternatively, a more formal targeting of gross domestic product can be considered, popularized but not necessarily followed in the 1970s and 80s. UK nominal GDP growth, whose inflation component is the even larger GDP deflator, has broadly followed the same path as CPI inflation. The latter has been above target most of the time since 2010, when nominal GDP started to recover. In practice, this probably works best when trend GDP growth is predictable, so that any overshoot can only cause transient damage to inflation.
A main vulnerability, however, is its reliance on GDP estimates. These are, unlike CPI or RPI data, false unless revised quarterly and systematically. Credibility risks being undermined if Bailey’s letters to the new chancellor constantly blame inflation overshoots on the purity of the data. It might therefore be better to supplement the IPC(H) with a bag of activity data and evidence from the Bank’s regional officers. But that’s not a world away from current practice.
So unless the independence of the Bank is withdrawn, there are, after 25 years, real opportunities to make the review constructive. It must be thorough, apolitical and not drag on. Because the uncertainty in the meantime could put even more pressure on the MPC to accelerate rate hikes and intensify quantitative tightening. If this exacerbates stagflation, Truss may not get the full recovery she needs before the next general election.
Neil Williams is Chief Economist at OMFIF.
Source of images: British government.