My column in Con Home: Inflation, interest rates and the case for a shake-up at the Bank of England
Updated: Nov 6, 2021
In the wake of my recent column for Con Home, on the need for a pro-growth economic policy, which generated much interest, I have agreed to write a forthnightly column.
Dr Gerard Lyons is a senior fellow at Policy Exchange. He was chief economic advisor to Boris Johnson during his second term as Mayor of London.
This summer, the House of Lords' Economic Affairs Committee, chaired by Lord Forsyth, criticised the Bank of England for its “utterly complacent” approach to tackling inflation. It needn’t have stopped there. It could have questioned the Bank’s approach to financial stability, too.
The latter may come to haunt the economy in coming years. Meanwhile, the consequences of the former are already evident as inflation rises.
Whether these impact the Government’s re-election chances is unclear. They easily could, since they will impact the economy and living standards - which should raise questions about whether the Bank is held sufficiently to account, and how Westminster views monetary and financial matters.
This week the Bank’s monetary policy committee (MPC) meets, with the focus on whether they should raise interest rates. Since the 2008 financial crisis, central banks have become increasingly powerful as monetary policy has been the economic shock absorber. Interest rates have fallen to record lows, and the balance sheets of central banks have soared via quantitative easing (QE). Such unconventional and unlimited policies have created an environment where debt levels have soared.
Current monetary policy raises some key concerns.
Inflation risks need to be taken seriously. The Bank’s actions over the last year suggest otherwise. It has behaved like a driver who has kept their foot down on the accelerator while whizzing past warning signs on the road: beware cost pressures ahead, dangerous inflation pressures imminent.
When growth was recovering and inflation rising, it chose not to act. On it went, printing money through QE. Moreover, its messaging was that it did not need to act - dismissing those who warned about inflation.
Now, though, the Bank appears keen to put its foot on the brake just as the economy faces a steep hill, with a likely cost of living squeeze approaching, which higher rates would add to. Timing matters in policy decisions. Hiking earlier would have been easier for the economy to cope with.
During a changing inflation climate, consensus expectations can be slow to adjust. This was so in the early 1970s, when there was a shift from low to high inflation. And it was also true in the early 1990s, when the consensus was slow to appreciate how the rise of China and globalisation was leading to low inflation.
The lesson is that the Bank should be more on the front foot, as the current conjuncture of lax monetary conditions and rising inflation raises risks. If inflation were to rise significantly, it would be harder to curb.
Which “p” is it? Will this rise in inflation pass through quickly, persist or become permanent? Central banks have called the rise temporary, believing it is not permanent. I would agree.
However, by claiming it is temporary, the Bank gives the impression that it does not need to act. I think that is wrong. It has not differentiated between inflation passing-through or persisting, and how monetary policy responds could have a critical bearing on this. Lax monetary policy risks inflation persisting for the next year or two.
Strangely, the Bank never mentions “money” in the text of its quarterly Monetary Policy Report. Instead, its focus is on inflation expectations and on output gaps - the latter giving a gauge of spare capacity, to help guide their thinking. However, measures of output gaps are not always accurate.
Another problem is that current monetary policy may feed financial instability. Policy rates of close to zero mean there is a search for yield, with financial markets not pricing properly for risk. That is worrying enough – as 2008 showed – but also, now, the Bank is the biggest buyer of government debt. This means that the price of government debt and borrowing yields are driven heavily by a non-commercial buyer, and do not reflect demand and supply.
Of further concern is that ultra-loose monetary policy feeds asset price inflation and wealth inequality. Its consequences are not consistent with levelling up.
Equally, levelling up needs to ensure small firms have access to sufficient finance. In 2019, in response to an insightful report on the future of finance that it had commissioned, the Bank noted that the funding gap facing small firms was £22 billion. How can such a mammoth figure be stated without senior figures at the Bank realising that it requires attention?
The Court of the Bank, its governing body, does a poor job in holding the Bank to account. Hence the important role of the House of Lords Economic Affairs Committee and the Treasury Select Committee. Yet, perhaps, even greater scrutiny is called for, and maybe this should be part of a wider shake-up of economic policy setting in the UK, including other aspects of the Bank.
Part of this shake-up should be avoiding group-think and increasing diversity of thought - something the Bank notably lacks. David Blanchflower, the excellent labour market economist, was an exception when on the MPC from 2006-09.
He has raised questions not only about the need for more diversity in gender and race, but also in backgrounds (university and social) and, critically, diversity of thought. Only last month, he asked: “Where’s the out-of-the-box thinker?”
It may also be time to re-examine the remit of the Bank. Inflation targeting may no longer be the best approach. I have called for a nominal GDP target, which has been subsequently endorsed by Sajid Javid and Lord Jim O’Neill.
The international role of the Governor in speaking up for the UK and the City is a role that should be exploited more. I have spent a quarter of a century attending and speaking at global policy fora, whether it be Davos, the IMF among others. Often the only two people who speak up on behalf of a country’s economic outlook are the finance minister or central bank governor. The UK needs more of this.
What next? Only a few weeks ago the MPC unanimously voted to keep its policy rate at 0.1 per cent and to retain its corporate bond purchases at £20 billion, and 7-2 in favour of continued QE to reach £875 billion purchases of gilts. No policy setters questioned the buying of corporate debt when it started, which they should have, and only recently has opposition to QE emerged.
Since that meeting, and despite conflicting economic data, the message from a number of MPC members, including the Governor, has been hawkish. While keeping the right foot down on the accelerator through QE, they now appear keen to put the left foot down hard on the monetary brake. "Reactive" best describes this approach, instead of it conveying confidence about being ahead of events and reading the road ahead.
The debate now, though, goes wider than simply raising rates. For the markets, the issue is whether central banks exit via tapering or tightening? The US Federal Reserve has made clear it will exit via tapering its asset purchases. My view for some time has been that QE should have been halted and reversed. Perhaps exiting via tapering should be given more weight now.
The Bank's plan is to exit through higher rates. The markets expect a hike this week, from 0.1 per cent to 0.25 per cent. The normalisation of monetary policy may be about to start. Perhaps it is an appropriate time for Westminster to take more of an active interest in the workings of Threadneedle Street, since these have implications for us all. The Bank is not beyond reproach just because it is independent.