By Howard Davies/London
The performance and mandate of the Bank of England (BoE) have become central issues in the contest to succeed Boris Johnson as leader of the Conservative Party, and therefore as the United Kingdom’s prime minister. But with recent reviews of other leading central banks offering little guidance amid today’s surging inflation, it might make sense to revive an old idea for reforming the prevailing anchor for monetary policy.
It is not surprising that the BoE’s performance is in question, given the central bank’s 2% annual inflation target. With UK inflation currently running at 9.4% and expected to exceed 13% later this year, something has clearly gone wrong. But some of the Conservative leadership candidates, and notably the frontrunner, Liz Truss, have gone beyond merely criticising BoE Governor Andrew Bailey for taking his eye off the ball. They talk about changing the BoE’s objectives, or even its very status. Truss has pledged to alter its mandate to toughen its focus on inflation, and one of her lieutenants has asked whether the BoE is “fit for purpose in terms of its entire exclusionary independence over interest rates.”
No, I don’t know what that means, either, but it sounds threatening. Others have talked about being “more directive in setting the BoE’s mandate” and suggested that some of today’s inflation has been caused by growth in the money supply. That hints at a possible reintroduction of money-supply targets, which were in vogue under Margaret Thatcher’s government in the early 1980s.
As it happens, I had the grand-sounding job title of “Principal, Monetary Policy” in the Treasury in those far-off days when the government set interest rates to meet money-supply growth targets. It didn’t go so well. We tried several different measures, but none were reliable. This proved the validity of (Charles) Goodhart’s law: When a measure becomes a target, it ceases to be a good measure.
While there is no clear alternative to the BoE’s inflation-targeting regime, which has been in operation since 1997, some kind of review seems likely. In fact, the BoE is a little unusual among leading Western central banks in not having been “reviewed” in recent years. The Bank of Canada, for example, is subject to such an exercise every five years. The most recent review, at the end of 2021, left in place the bank’s 2% inflation target, though with some new language about the emphasis policymakers should place on unemployment.
In New Zealand, on the other hand, the central bank’s governance was changed significantly last year. A committee, rather than the governor acting alone, will make monetary-policy decisions, and the bank will pay more attention to house prices. Likewise, Australia’s new Labor government recently launched an external review of the Reserve Bank’s mandate.
The two most important Western central banks – the US Federal Reserve and the European Central Bank (ECB) – suffered nothing so undignified as an external assessment, and both have been allowed to mark their own homework. The Fed’s review in 2020, when US inflation was persistently low, took its mandate as given, but concluded that “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” The Fed has certainly achieved that over the past year, though I doubt that 9.1% annual inflation was exactly what it had in mind. I suspect that the term “inflation averaging,” like “forward guidance,” will now be put out to pasture.
The ECB’s review, also undertaken against the background of stubbornly low inflation, reached a similar conclusion. The bank made its 2% inflation target symmetrical, which it always should have been, added some words about taking account of asset prices (especially housing prices), further downgraded the role of monetary aggregates, and looked forward to “a transitory period in which inflation is moderately above target.” On that final metric, the ECB also has in a sense outperformed, but the cure has proved even worse than the deflationary disease.
So, there is little in these other reviews that could provide a useful model for the BoE in the current circumstances. But there is one idea that could be worth considering, though it also was conceived at a different time and for different problems. When he was chief economist of the International Monetary Fund, Olivier Blanchard argued that a 2% inflation target was too low because there could be long periods when interest rates were at the zero lower bound, meaning that any further monetary loosening would entail quantitative easing, with uncertain results. With a 4% inflation target, those periods would be far shorter, and the monetary authorities could retain the ability to manipulate interest rates.
One can argue that such a change would be more suited to a time when inflation was too low. But it could nonetheless have some relevance today. Squeezing double-digit inflation out of the system will almost certainly be costly in terms of lost output and jobs. Some of the froth may disappear as energy prices stabilise, even at a high level. But getting inflation back down to 2% will be tough, given the way inflationary expectations are becoming embedded in wages and prices.
We may need something approaching former Fed Chair Paul Volcker’s double-digit interest-rate onslaught, which brought down US inflation sharply in the early 1980s. Yet, even Volcker declared victory when he had reduced annual price growth to 4%.
The risk of raising the inflation target when price increases are out of control is obvious. But doing so might give central banks a bit more flexibility, and bring about a more stable monetary-policy regime in the longer term, for the reasons Blanchard set out. Such an outcome would certainly be better than putting interest rates back under political control. – Project Syndicate
* Howard Davies is Chairman of NatWest Group.
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