The writer is director of the National Institute of Economic and Social Research
Since it was granted operational independence, the Bank of England has had an honourable record in controlling inflation. Its Monetary Policy Committee met its inflation target in the quarter century from May 1997 to May 2022. But as has been well documented in the past year, it seems to have blotted its copybook.
Inflation has peaked in double digits and the figures just announced for this April fell much less than the BoE had forecast. It seems likely to stay above target for the rest of this year and the next, raising the strong possibility of monetary policy having to induce a recession to attain price stability for the first time since the early 1990s.
No doubt some mistakes have been made, but what is just as important are the lessons we need to learn in setting a path for an independent central bank in the second quarter of the 21st century.
First, we need to focus BoE resources on understanding inflation, perhaps even renaming the worthy quarterly Monetary Policy Report the Inflation Report once again. And we must reiterate that inflation is neither temporary nor permanent; it is controlled by the central bank, which responds to the shocks given the structure of the economy and the instruments at its disposal.
That does not mean that we should become inflation zealots; the MPC can choose to move gradually in response to an inflation shock if it judges that output or employment would be too violently affected by an immediate return to price stability.
Second, we desperately need the right narrative to communicate clearly to market participants and to households, who have been shocked by the rapid increase in the bank rate.
The UK is a small open economy with a supply side hampered by the effects of Brexit and labour and supply chain shortages that have, in turn, been exacerbated by food and energy price shocks.
We neither emphasised the size of these shocks nor their specificity to the UK. As a result, we were not sufficiently clear about the need to signal an early start to the normalisation of monetary policy, which was too often conflated with tightening.
The situation in the US, for example, a large producer of oil and food, was quite different and our rates need not have followed the same path.
Third, we need to move away from one model, one forecast and one interest rate choice. Models are nearly always wrong but they have their uses. And, by and large, that is to help us think about risks. It is the central bank’s job to explain and manage those risks on society’s behalf.
The risks of higher and lower inflation include assessments of the transmission of policy and the response to a decisive shift of regime, which would mean permanently higher interest rates. It is reductive to translate that task of risk management into a single interest rate choice every few weeks.
Rather, the central bank needs to spell out the path of rates required to manage those different risks. Or at the very least allow external members of the MPC to set out their thinking at press conferences. That so many of these risks are financial in nature strengthens the case to merge the MPC with the BoE’s Financial Policy Committee.
Fourth, there is a perception that the BoE has been taken over by the Treasury since the financial crisis. External and internal MPC members have been appointed by the Treasury, with the bank increasingly providing a kind of retirement home for former Treasury officials.
At a time when excessive levels of quantitative easing have been blurring the boundary between monetary and fiscal policy, this is unfortunate.
Although it is highly desirable to have a co-operative relationship between the Treasury and the BoE, the political antennae of the former should not be transmitting a signal to the latter.
The BoE needs to focus on the plumbing of monetary and financial markets without any suggestion of interference from the other side of town.
And so the government and the Treasury should have been warned not to be tempted to take credit for any fall in inflation.
Unfortunately, it is also clear that the level of public understanding of inflation, interest rates and debt is not where it ought to be. Some 30 years ago, the BoE did a sterling job in explaining the case for price stability. The MPC and central bank can do more now by holding their policy meetings as set-piece events around the country.
This would not only support regional economies but also promote a national focal point for the BoE’s vital work.
