Rethinking central bank independence

The Bank of England was in the news once again last week, with the Governor Andrew Bailey and his senior colleagues Ben Broadbent and Dave Ramsden meeting the Treasury Select Committee on Thursday. The theme was the UK’s inflation and its persistence, and the Governor was very clearly on the defensive in the face of some critical questioning from the Committee.

Unusually the meeting with the MPs was held at the Bank, but home turf did not make it an easier ride for the Bank team. Bailey’s evidence was detailed and in the main very technical – it is his forte and he clearly prefers dry statistics to more expansive narrative-based discussions, which are not his strength. But not surprisingly the one bit that both the MPs and then the press picked up and highlighted was his insistence that the inflation the UK is experiencing was not a consequence of Quantitative Easing, and not the Bank’s fault. And not surprisingly, the press were pretty scathing in their assessment of this.

There is clearly some truth in Bailey’s claim. On the one hand the decade of QE before the pandemic did not cause any inflation (except, importantly, in asset and house prices); and on the other hand the more recent inflation is due at least in part to much higher energy prices and labour shortages. But that is very far from the whole picture, as it ignores the very different economic backdrops to the two versions of QE.

Put simply (but this is not a gross oversimplification), QE after the 2008 financial crisis was to address the shortfall in growth due to a shortage of demand. It helped to keep demand up and was not then inflationary – there was no inflation in 2020 even after a decade of QE. But after 2020 the collapse in growth was due to a shortage of supply. QE cannot solve that and by boosting demand which supply was already not meeting merely caused a rapid expansion in the money supply.

And so inflation? This is the causality Bailey is seeking to deny. And he has an uphill task in trying to do so. Pretty much every monetarist economist was saying as long ago as September 2020 that money supply was growing too fast and would produce inflation. And pretty much every central banker denied it, and went on denying it until at least September 2021. Since when pretty much every major economy has had the inflation the monetarist economists predicted, warned about and urged action against.

That fact alone damages central bankers’ credibility, which many would say Bailey is not over-endowed with to start with. But on top of that, as well as claiming that the inflation we have is not a monetary phenomenon, Bailey has now presided over 18 months of increasing interest rates to try to stop it.

The irony is that this is a monetary solution. To elaborate, either the inflation is caused by excess money, in which case it is sensible to tighten monetary policy, or it is not and raising interest rates cannot be the answer and will only cause an avoidable recession. But the Bank cannot have it both ways – they cannot claim that the inflation is not a monetary inflation but is addressable by monetary policy!

And so the aftermath of QE continues to play out. Jacques de Larosière, a former governor of the Banque de France, and now at the age of 93 widely regarded as the elder statesman of central banking, has likened QE to the classic tale of the sorcerer’s apprentice, whose clumsy use of magical powers produces an uncontrollable trail of disaster. QE seemed like magic – it worked, but central bankers did not fully understand how, and did not appreciate how the changed circumstances of the pandemic would alter its economic impact. And now it has unleashed the inflationary demons.

The criticism levelled at Bailey et al is that they had a magic tool called QE, it seemed to work in the 2010s with no unwanted side-effects, so they unthinkingly pulled the same lever in 2020 despite very different circumstances.

de Larosière went on to warn that through the misuse of QE, central banks have weakened firstly their own balance sheets, secondly their reputation and thirdly their independence. The first is unarguable, and many major central banks are facing heavy losses on their holdings of bonds they bought under QE. The second is also I would say true, with few central banks emerging from the inflation of the last 18 months with their public esteem intact. But it is his third claim, that the episode damages the principle of central bank independence, that is most worthy of further consideration.

At this point, if I was in academia I would be forced to issue a trigger warning that some Established Truths, bordering for central bankers on Sacred Shibboleths, are about to be discussed and even challenged. For it has been an article of faith for central bankers for at least the last 25 years if not longer that the best way to run the monetary side of an economy is for the central bank to be independent, and for it to have sole responsibility for controlling inflation. This received wisdom has been so powerfully espoused that challenging it is not easy, not least (as central bankers are always very keen to point out) because the period of widespread central bank independence neatly coincided with the low inflation of the 2000s and 2010s. QED, as we were repeatedly told.

But central bank independence is neither well-based in political theory nor evidence-based in practice. The elephant in the room with central bank independence is the question of democratic accountability, and how in a democracy one rationalises the will of the people and the oversight of the electoral process with the actions of an unelected agency. Gordon Brown was asked exactly this question when he made the Bank of England independent in 1997; he ducked it then and in the 26 years since no clear answer has emerged.

The defence that supporters of keeping independent central banks at one remove from the political process put up is usually threefold: that controlling inflation and managing interest rates is too important a task to leave to politicians and the temptation of abuse for electoral gain, that it is a technical matter which should therefore be left to technocrats, and that it works.

All three of these are presented as “self-evident truths”. But all three are challengeable. The idea that monetary policy is too important to entrust to politicians begs the question of why this decision is so unique and what we should do with real life-and-death decisions, such as for example declaring war. Should they too be considered “too important to entrust to politicians”?

Secondly, the suggestion that monetary policy is “merely a technical matter” without political or social consequences cannot be maintained either: changing interest rates creates winners and losers in society just as much as any move the Chancellor might make in his budgets. The extended period of ultra-low interest rates in the period to late 2021 favoured asset-owners and existing house-owners, and the very sharp increase in interest rates since then has wrought havoc with the finances of many borrowers, most obviously young families seeking to buy a home. What is their political remedy? How do they express an electoral preference for an alternative approach?

But the supporters always had their fail-safe third argument – central bank independence is good because it works. The problem with this defence, which one might call the “bumble bee” argument (as in “Bumble bees should not be able to fly. But they do. So that proves they can”), is that it collapses completely the moment it ceases working.

Which many would say that it has. And it leads one to ask an awkward question: if Bailey and his Threadneedle Street colleagues are not responsible for the current too high inflation, were they in fact not responsible for the two decades of low inflation that preceded it either? Did they create that low inflation, or merely preside over it? How much was due to external factors such as the end of the Cold War, the increase in globalisation, new technologies and above all the entry of China into the world economy? As the press was quick to ask Bailey after his evidence, “If you are not responsible for the current rate of inflation, what are you responsible for and what is your purpose?”.

One country has gone further than just asking this question in the press. The new Labor government in Australia announced a review of the Reserve Bank of Australia (the country’s central bank) and its operations as one of their first acts on assuming power in May 2022, and last month it was published. Interestingly, the review quite quickly widened from looking at just the operation of the RBA in isolation into considering its place in the conduct of national economic policy more widely, its interaction with the Commonwealth Treasury and the nature of its political oversight (including whether the Commonwealth Government should have a right to direct the bank).

These questions strike at the heart of the received wisdom of central banks, their place in society and their independence. They suggest that the central bank’s role cannot be narrowly defined and treated as “merely technical”, their actions and decisions cannot be isolated from the rest of national economic management, and their governance cannot be isolated from the political process. Australia appears to be moving towards a reintegration of the RBA into the political management of the economy, and its independence is very definitely part of that debate and in play.

I think this is right, and I suspect Australia will not be the last country to investigate how its central bank works following the inflation of the last 2 years.

But back to Andrew Bailey. There is every chance that UK inflation will fall in the coming months, perhaps quite sharply. Energy prices are falling, and the huge increases of last summer will soon drop out of the annual comparison. Money supply growth is also falling sharply, adding monetary pressures to the real economy pressures on prices.

When this good news emerges, will the Governor still claim that it is “nothing to do with the Bank”? Or will he suddenly decide that he can affect inflation after all?