Over
the past summer things did heat up for Bank of England Governor Andrew Bailey. After
a string of Bank forecasts that underestimated inflation, and pressure from the
House of Commons Treasury Committee to conduct a review of its forecasting
record, the Bank has established a committee chaired by Ben Bernanke to evaluate
its forecasting methods. In addition, in November the Economic Affairs
Committee (CEA) of the House of Lords issued “Making an independent Bank of England work
better,” a report on the
performance of the operational independence that was granted by the Bank of
England Act 1998.
There
is much to praise in the Lord’s report. Unfortunately, the report was marred by
its analysis of inflation forecasting and by its inconsistent views on operational
independence.
The
Lord’s report criticizes the Bank’s forecasting record, noting that it, like
other major central banks, systematically underestimated the level and the
persistence of recent inflation. This isn’t surprising; did anyone predict the
pandemic or Russia’s invasion of Ukraine? What is surprising was the call in
the Lord’s for the Bernanke-led review “…to explain the value of models that seldom predict anything other than a
return to the two per cent target over their forecast horizon.” (Para. 134) Why
surprising? Whatever model the Bank uses to generate forecasts, those forecasts
depend, explicitly or implicitly, on an assumption about monetary policy. What
would it mean then if the Bank published a forecast for inflation that did not
show a return to target? If the Bank’s is credibly committed to its inflation
target, all its medium-term forecasts should show a return to two percent
inflation. The most recent remit letter from the Chancellor to the Bank
Governor actually, states “…monetary policy remains vital in supporting
businesses and households by ensuring inflation returns to target
sustainably in the medium term.” (emphasis added). For the Bank to
forecast otherwise would be a red flag under any system of accountability. A private forecast might
show inflation not returning to target, but that expresses a lack of confidence
in the Bank’s commitment to its primary objective. A firm that signs an
important contract to deliver goods at a future date but then immediately turns
around and says they forecast delivering only half the promised amount would
certainly be punished by financial markets.
A second issue with the Lord’s report is it seemingly calls for undercutting the Bank’s operational independence. The Bank’s primary objective – the inflation target – is set by HM Treasury, but with operational independence, the Bank has the freedom to act as it sees best to achieve that target. However, the report acknowledges that achieving the target may require the Bank to adopt a policy stance “... that counteracts the economic impact of the Government’s fiscal policy. It is therefore imperative that the Bank’s activities and its remit are effectively scrutinised by, and its officials are held accountable to, Parliament.” (para. 161) But that is exactly what operational independence is meant to prevent. It is the purpose of central bank independence, not a flaw, as the report recognizes when it states that “It is the Government’s job to ensure they (fiscal policy and the remit) are consistent with each other, not the Bank’s.” (para. 46)
If the Government adopts an expansionary fiscal stance that the Bank believes will lead inflation to rise above target, the Bank must raise interest rates to offset the fiscal expansion. If it can’t do that for fear of being scrutinized by the fiscal authorities, what is the meaning of operational independence? And how then can the Bank be held accountable based on whether it achieves the inflation target?
The
report contains very little discussion on how to hold the Bank accountable. The
issue is not whether an independent central bank should be accountable. Of
course it should be. The issue is how accountability should be enforced. The
original Bank of England Act 1998 Act established that the Governor write a
letter to the Chancellor explaining any deviation from the inflation target of
one percentage point or more. Being forced to write a letter seems like a very
weak disciplinary punishment for letting inflation average almost 6 percentage
points above the target since February 2021. Would the CEO of a private company
whose profit guidance was that far off for almost two years still have a job?
