How independent is the Old Lady?
Neil Record worries that the Bank of England’s bias towards low rates correlates with a political imperative to inflate away public and financial sector debts. So is monetary policy now controlled by Whitehall, rather than Threadneedle Street?
‘Today’s UK inflation rate is 4% - twice the government’s target of 2% per annum.’ With headlines like this, anyone who has read the Bank of England’s (BoE) 1997 inflation remit would naturally expect it to be climbing up the interest rate ladder to get inflation down. Of course, raising interest rates is painful (to politicians especially), but the whole point of making monetary policy independent of political interference was to inject a strong measure of objectivity into the process of inflation control.
But the BoE’s monetary policy committee (MPC) has left nominal interest rates at record lows, and real rates strongly negative. The bank makes the argument that there is excess capacity in the UK economy, and that inflation is largely imported and will be above target only temporarily. Putting up interest rates now would not immediately affect inflation, they argue, and by the time the effect started to kick in, inflation would be going down on its own accord.
The BoE claims that it is trying to target future inflation. But to do this requires a good track-record in forecasting future inflation. Failing that, the BoE would probably be better off with two simple rules: inflation higher than target now? Raise interest rates. Inflation lower than target now? Lower interest rates. Unfortunately, the BoE’s inflation forecasting, historically very good, appears on the face of recent data to be incorporating an institutional bias - let’s call it ‘wishful thinking’.
In the 12 quarterly inflation reports from August 2001 to May 2004, the BoE’s average forecast for inflation a year ahead was 2.2% pa. Outturn inflation was 2.3% pa. Virtually spot on. In the quarterly inflation reports from August 2004 to May 2007, the average forecast for inflation a year ahead was 2% pa, and the outturn inflation was 2.3% pa. A little optimistic, but well within normal forecasting margins.
By contrast, in the reports from August 2007 to May 2010, the BoE’s average forecast of inflation a year ahead was 2.1% pa, and the outturn inflation was 3.2% pa. An average error of 1.1% pa, and for three full years an average outturn above the supposed upper limit of acceptable inflation band (which the finance minister had set at 3% pa inflation).
Those errors are not exceptional for their scale - after all, this period covers the credit crunch, when a series of huge shocks was hitting the global economic system. What is interesting is the bias. The economists in the BoE are second-to-none, and the depth and detail of analysis in the inflation report remains first class. So is this apparent forecasting bias a matter of chance, or does it indicate something deeper?
The BoE (via the MPC) has been transparent in its reasoning for maintaining ultra-low rates, arguing that during the collapse of demand and nominal GDP in 2008-09, a large gap opened up between the productive capacity of the UK, and its current level of output. It further argues that this excess economic capacity (high unemployment, idle machinery, empty offices and factories) would bear down on prices so inflation would be benign. By giving a heavy weighting to this excess capacity factor in its inflation forecasting models, the BoE gave itself permission, through ‘on-target’ inflation forecasts, to maintain ultra-low interest rates.
Ultra-low rates, however, are not politically neutral. They satisfy two very important desires of the incumbent government - one overt, one covert.
The overt desire is to keep interest rates low to keep consumer and business confidence bouyant. This is entirely understandable, but illustrates the underlying conflict of interest that prompted the former prime minister, Gordon Brown, to grant interest-rate setting powers to the BoE.
The covert desire is more worrying. Two important UK economic sectors are now very - probably dangerously - indebted. These are the government and the banks. Much of the government’s and all of the banks’ debt is nominal, not index-linked. I surmise that it is strongly in the interest of government to engineer a modest level of inflation (not too much, say 4-5% pa) to allow the real depreciation of these exceptionally high debt levels at the expense of the real purchasing power of holders of nominal assets - savers and the majority of pensioners.
This covert transfer of emphasis from savers to borrowers is now in full swing, and sends a damaging message to the general population: “Borrow, don’t save, because that is where the interests of the people in control of the economy lie.” And for the Bank of England even to appear to be colluding in this runs the risk that inflation does not stay at 4-5% pa, but takes on a life of its own.
We should have already learned the lesson of how much harder it is to put the inflation genie back in the bottle than it is to take it out.
Neil Record is founder and chairman of Record, a visiting fellow of Nuffield College, Oxford, and a former economist at the Bank of England