A decade ago, respect for central bankers peaked. In three words, Mario Draghi’s commitment to “do whatever it takes” ended the eurozone crisis and demonstrated the value of strong, independent institutions. Credible statements from trustworthy politicians work wonders. But Draghi’s intervention as head of the European Central Bank was the highlight.
Donald Trump repeatedly lamented that the Federal Reserve’s rate hikes between 2017 and 2019 would undermine his economic success. Calling Fed Chair Jay Powell an “enemy” of the US and his colleagues “idiots” were just two of many insults the former president has hurled.
After Trump came Turkish President Recep Tayyip Erdoğan. He handpicked Şahap Kavcioğlu in early 2021 as central bank governor, who could finally be counted on to implement the president’s unorthodox idea that lower interest rates would lower inflation.
Now, with UK inflation heading into double digits, frontrunner Liz Truss has pledged to review the independence of the Bank of England. Her allies, like likely next chancellor Kwasi Kwarteng, have issued implicit threats, saying “we have to look at what went wrong”.
It would be easy to present Trump and Erdoğan as cautionary tales for Truss. Powell ignored Trump’s bullying. Rightly so, because a few years later we know that the Fed’s main mistake was tolerating interest rates that were too low for too long, thereby fueling inflation. Turkey, which cut interest rates on Erdoğan’s orders, is now suffering from an official inflation rate of 79.6 percent in July, with many economists believing the real rate is even higher.
However, this conclusion would be wrong. Many of Truss and Kwarteng’s economic positions are bizarre, but they are correct in their diagnosis that something is wrong at the BoE. Of course, high energy prices have done much to push up inflation, but the UK is suffering from the worst of all worlds – the US overdemand sickness, a UK-specific contraction in labor supply that the BoE has failed to notice, companies comfortable with prices increase, and workers determined to protect their wages. No wonder inflation is 13 percent.
Attempting to defend the BoE’s independence in this environment, Governor Andrew Bailey has a problem. The traditional argument is that if independence were relaxed, all hell would break loose and Britain would return to the high inflation of the 1970s. This has already happened.
Without this card, the BoE has resorted to the risky strategy of blaming others and insisting it made no mistakes. According to Bailey, the BoE is also a victim of high inflation and could not anticipate Russia’s invasion of Ukraine and the resulting rise in natural gas prices. “We don’t make politics after the fact,” Bailey likes to say.
For those who want to protect valuable economic institutions like the BoE, the governor’s position is impossible to support. Looking back is valuable. It allows us to learn lessons. In any case, Bailey didn’t need to look back, he just had to listen to his chief economist in February 2021, who warned that the “greater risk right now is the central bank complacently letting the inflationary (big) cat out of the bag.”
Instead, Bailey falls into the trap described by London School of Economics Professor Ricardo Reis of blaming rain for getting wet despite holding an umbrella. As said riceif you have a 2 percent target, inflation rates in excess of 7 percent for well over a year are almost always the fault of the central bank.
The new prime minister and chancellor will therefore have full powers to review the central bank’s mandate. I think it is unlikely that they would change the BoE’s legal requirement to “maintain price stability” or use the Treasury’s reserve powers to run the central bank’s monetary policy committee.
Instead, Truss may want to give the BoE a new definition of price stability. She has indicated that she is interested in a nominal gross domestic product target. Since it was also up at an annualized rate of 9.1 percent in the second quarter, it wouldn’t make much of a difference.
But Truss and Kwarteng could operate perfectly within the confines of the BoE’s operational independence to bolster their stimulus. You could underline the importance of controlling inflation in the Chancellor’s annual letter setting the BoE’s inflation target.
Better still, Kwarteng could write a stronger reply to the BoE the next time it has to declare an inflation deviation of more than 1pp from target. Traditionally, the BoE says that something has happened beyond its control and that it has already taken action to rectify the matter. The chancellor then responds with a relaxed acceptance of the central bank’s arguments. Instead, the Chancellor’s letter should become an appropriate means of challenge and accountability for the BoE.
While it might hurt the egos of some senior BoE officials, it would in no way send the UK down the dangerous paths of Trump or Turkey. Central bankers should welcome the additional restraints. Too much freedom and too little accountability for unelected officials is unhealthy in a democracy.
chris.giles@ft.com
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