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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Tony Yates is a former professor of economics and senior adviser at the Bank of England.
On 15 November, Rishi Sunak declared victory: October’s CPI inflation release came out at 4.6 per cent year-on-year, having peaked at 11.1 per cent, meaning he could claim to have delivered on a January pledge to ‘halve inflation’ over 2023.
Less than a fortnight later, the House of Lords Economic Affairs Committee reminded us whose job it actually was to control inflation, and how well they thought that job had been done, in a report titled ‘Making an Independent Bank of England work better’.
They wrote:
…the persistence of above-target inflation over this period… reflects errors in the conduct of monetary policy.
Their ‘report’, really more of a extended blog post, states the Lords’ collective views, interspersed with an account of witness evidence. So it seems appropriate to respond with a blog post and let the comments section fill in for the witnesses.
The main point it gets wrong is fundamental: high inflation might not have been a policy error, but actually the best option out of a bad bunch under the circumstances.
The common thread across the policy challenges the UK has recently faced was a throttling of supply. The compounding effects of Covid-19, Brexit and the war in Ukraine created scarcities of manufactures, then later energy and food, that impoverished us and meant real wages — the amount of stuff our salaries can buy — had to fall. We could have had sharply tighter monetary and fiscal policy, and this may have generated inflation much closer to target, so that real wages fell far more via nominal wage cuts than price rises. But doing so would probably have generated a huge recession.
The inflation target remit the Bank of England’s Monetary Policy Committee follows gives it the licence to navigate shocks in this way:
Attempts to keep inflation at the inflation target [when there are ‘shocks and disturbances’] may cause undesirable volatility in output due to the short term trade-offs involved.
Very high inflation was just the MPC doing its job facing very large ‘shocks and disturbances’. Inflation proved less transitory than first predicted. But supply turned out worse than predicted. It was reasonable to respond to this incremental news by accommodating. If you accept the MPC’s revealed view of the inflation-output trade-off, the recurring inflation forecast errors don’t imply policy errors.
The Lords point to survey evidence showing dissatisfaction with the Bank to support their case:
I think this tells us very little. Respondents will struggle to understand how the Bank weighs its competing objectives and the constraints it faces, and I dare say the satisfaction ratings would have been much much worse after a protracted and deep recession. People don’t like that the nation has got poorer and they unfairly blame the Bank for that.
Having said that high inflation was definitely bad — even though it might have been the best route possible — the Lords press on to see what can be done to stop a repeat.
One view it came to was that the MPC had lacked diversity of thought and models. Lord Mervyn King not recusing himself from this report, an act that leaves the former Bank of England governor marking the homework of his successors, now comes into focus. He was recorded making some unfortunate remarks — not repeated in this report — that lack of diversity of thought was a result of focusing too much on achieving diversity in ethnicity and gender. (Sidenote – the most dovish and hawkish MPC members recently have been women.)
Still, King signing up to their Lordships’ critique of the Bank’s tools is a little odd, since they are pretty much those that King was equipped with during his own tenure. The comment also seems not to recognise that MPC members describe themselves as being at liberty to overwrite their models using their judgement, reserving the same discretion as King himself did back in the day.
The report suggests that the Bank had not placed enough emphasis on models of money, and features a cameo by the irrepressible Tim Congdon, who wishes that more people relied on the quantity theory — monetary value of transactions = money supply*velocity — one that is in fact an identity that always holds, and most economists accept leaves open what causes what and how money demand will vary. It is not a guide to forecasting: it is an aid for students to understand accounting.
The Lords welcome the ongoing review by Ben Bernanke of the Bank’s “forecasting and related processes”, but Bernanke himself is unlikely to suggest a reinstatement of old monetary models of inflation, given that he was a co-architect, in his time at the Fed, of the modern consensus to bin them.
To fix this lack of diversity that might not exist and caused a problem that might not have been a problem, the Lords recommend a review of the MPC appointments process by HM Treasury and the Court of Directors of the Bank. A guiding principle in the modern-day monetary framework thus far in the UK has been that the Bank takes the operational decisions to set policy, but that the Treasury — on behalf of the rest of us — does the rest, setting the goals and hiring the key staff. In my view, it would be an unwelcome tilt of power toward the Bank for it to get involved in the policy committee hiring process, so I hope this recommendation is ignored.
The Lords are clearly uncomfortable with the MPC’s use of quantitative easing (QE), its economic side-effects and what it has done to central bank independence. One concern, not stated bluntly here, is that the Bank would be leant on not to sell its gilts back, so that they could be permanently monetised. The MPC’s steady reversal of QE should be allaying this worry, finally. This part of the report is another place where Lord King’s participation makes for good theatre. I’m reminded of an ex-BoE friend’s stylised version of the 2021 process of writing the HoL report on QE: “What about all this QE then?!” “Well, you started it!” etc.
One recommendation which intrigues me is that Lords ask for “a memorandum of understanding which clarifies how the interaction between monetary policy and debt management should operate.” The main effects of QE are in changing the net amount of long term gilts held in the private sector. More scarcity in the private sector bids up the price and lowers the term premium. For the MPC to achieve its monetary goals it has to hope that the Debt Management Office is not going to work against it.
Larry Summers and others pointed out that in the early phases of QE the Fed and Treasury were at cross purposes (see here for an example). An MOU could help MPC translate its gross purchases into anticipated holdings in the private sector net of DMO issues.
Given how meagre the thinking in this report is, it’s ironic that the Lords also wish for stronger mechanisms by which to hold the Bank to account. They take aim at the Bank’s ‘Independent Evaluation Office’ — an Office that is actually located in the Bank and staffed mostly with staff rotated out of the Bank (and, later, back into it) — but in the circumstances they might just as well ask why they themselves did not do better. This is, ultimately, a report about a policy error that was probably not a policy error.
