Bank of England - Unfit For Purpose?

 This week the Bank of England will again be centre stage as it contemplates another rise in interest rates. Quite apart from its short-term actions, there is a powerful swell of criticism of the role of the Bank in exacerbating the current economic difficulties.

While it has died down somewhat now, there was talk in some quarters of altering the Bank’s mandate, or even of suspending its independence and returning to the situation before 1997 when monetary policy was effectively dictated by the chancellor.

Is criticism that the Bank has contributed to our current economic woes fair?

Let’s start with the background. In the wake of the global financial crisis of 2007, central banks operated a policy of low official interest rates and Quantitative Easing (QE) - that is to say, the purchase of financial assets, mainly government bonds, financed with newly issued money. The aim was to support aggregate demand and prevent the financial system from imploding.

At the time, there was a real fear in policy circles that we could be in for a repeat of the Great Depression of the 1930s with endemic deflation, not only of real economic activity but also of the price level. Low interest rates and QE were the response.

Some economists criticised this Bank’s actions at the time and argued that loose monetary policy would be inflationary. In the event, they proved to be wrong. Despite the huge injection of central bank money, the growth of the broad money supply remained subdued. In essence, the policy of QE pumped huge amounts of money into the banking system where it remained – inert.

True, inflation here did briefly exceed 5pc in September 2008, driven up by strong increases in commodity prices, and again three years later. But these upsurges were transitory. At the end of 2019, just before the coronavirus hit us, inflation was running at less than 2pc and it continued to be very low into the early months of 2021.

In response to the coronavirus crisis, the Bank reduced official interest rates from 0.75pc to 0.1pc and engaged in massive QE. According to some commentators, this was the height of folly. QE was an aberration that was bound to cause inflation.

I think this assessment was profoundly mistaken. Admittedly, QE was a risky policy and it proved more effective at boosting asset prices than the economy. Nevertheless, it was a perfectly legitimate tool of monetary policy once interest rates had effectively reached zero.

Of course, inflation can be a great evil but it isn’t the only one. The pandemic brought on a massive collapse of output but, remarkably, things could have been much worse. Another Great Depression would have been a catastrophe.

So, in my view, the Bank’s actions were broadly correct. The problem lay in not recognising early enough that inflation was emerging as a serious threat and that, accordingly, interest rates had to be raised pronto and the QE programme stopped, before soon being put into reverse.

In making this error, the Bank was unduly influenced by the experience after the Global Financial Crisis (GFC). In fact, there were two huge differences from that period – one monetary and the other real. The big monetary difference was that this time round the money supply expanded rapidly. In the early months of 2021, the annual growth of the broad money supply exceeded 15pc.

Moreover, this money wasn’t just sloshing around the banking system. The huge increase in government spending and borrowing to support people and businesses through the pandemic meant that additional money found its way into their bank accounts. They were thereby able to sustain their spending through the pandemic and afterwards. By contrast, after the GFC, the Government tightened fiscal policy.

The real factor that the Bank missed was the sharp fall in supply capacity induced by the pandemic and the measures taken to deal with it. In this country that fall was especially associated with a drop in the workforce. So strong monetary demand coincided with reduced supply, causing an upsurge of inflation.The inflationary forces unleashed by the Ukraine war last year intensified the crisis but a major monetary policy error had been made before the invasion of Ukraine. Inflation was already on the up and the Bank of England was already behind events.Now the Bank has to continue its catching up at an inauspicious time. As it raises interest rates, it will tend to increase the cost of funding the Government’s huge deficit. Meanwhile, the housing and commercial property markets are under pressure. Higher interest rates could precipitate large falls in the prices of both residential and commercial property. Moreover, the economy is struggling to avoid recession.It is, I suppose, a consolation that some people believe that very low interest rates contribute to weak productivity growth by helping feeble businesses to cling on and thereby continue to use resources in less productive ways. It would be better, so the argument runs, for such “zombie” firms to be allowed to go to the wall, and for their resources to be released into the economy for more productive use elsewhere. This is an attractive possibility but no one knows how large the “dead zombie” bounce could be.Yet it is surely fair to say that the policy authorities have paid insufficient attention to the medium-term inefficiencies engendered by ultra-cheap money, not only the sustaining of zombie firms, but also the boost to house prices, which has so distorted our economy and society.Moreover, the persistent tendency for interest rates to be very low, and often negative in real terms, has undermined the savings culture with baleful economic effects. This should carry lessons for policy once things get back to normal.

But what to do now? The Bank should raise rates this week by 0.5 percentage points to 4pc. It should keep raising rates until we reach a level that will reliably get inflation down to the 2pc target and keep it there. The Bank made a serious monetary policy error which contributed to where we are today. That can be forgiven. But it has no room to make another.

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Roger Bootle is chairman of Capital Economics. DT.