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A Tighter, Tougher Mandate! Getting a Grip on Inflation

Andrew Bailey, Governor, The Bank of England

Inflation should neither be blamed on fuel or other price hikes, nor indeed on politicians. It is, explains John Greenwood, determined by the Bank of England, which over two years allowed broad money to grow far too rapidly. As the new parliamentary year opens, tightening the Chancellor’s mandate to the Bank must be a priority, with proper sanctions put in place, including sacking the Governor, if the rules on money growth are, as they have been, excessively violated.

The surge in inflation has been a disaster for Tory hopes of re-election in 2024. It has been a devastating torpedo launched at the some of the party’s most cherished goals: ensuring growth of middle England’s incomes in real terms, keeping tax rates low, and promoting the competitiveness of British industry.

Although inflation is central to the party’s – and especially the prime minister’s – agenda, it is also something that ministers have very little ability to control. True, they can sometimes influence the price of energy through Ofgem’s price cap and energy guarantee scheme or bring pressure to bear on supermarkets to manage food prices downwards, but at the end of the day these are relative prices, not items that can long affect the overall level of prices.

Fundamentally, overall inflation is determined in Threadneedle Street, while Downing Street or Whitehall at best has limited ability to influence a few individual prices. Even if politicians are successful, for example in holding down the price of fuel, that means consumers and businesses now have more funds available to spend on other things; the overall level of inflation will be unaffected. Squeezing the balloon in one area simply diverts the pressure to other areas.

In view of these iron laws of the transmission of monetary policy and prices, the Tory party urgently needs to review the details of the mandate given to the Bank of England by the Chancellor, and the accountability of the Governor and his team for the outcomes. For if the party loses the general election due to be held in 2024, it will in no small part be due to Bailey’s inflation generated in 2020-21.

Currently the mandate specifies the 2 per cent CPI inflation goal but gives no guidance on how that target is to be reached. In my view the mandate allows far too much discretion to the MPC. On accountability, in the event of an overshoot or undershoot of the 2 per cent target by more than 1 per cent there is a requirement that the Governor writes to the Chancellor to explain what has happened, and the Chancellor normally writes back accepting the Governor’s explanation. These exchanges have become so bland and innocuous as to be meaningless – and certainly no sanction on MPC actions in future.

The target of 2 per cent CPI inflation remains the correct objective, but MPs need to be sure the Bank will not make fundamental errors in future. The main error in 2020-21 was to allow broad money (M4x) to grow far too rapidly. Using quarterly data, M4x peaked in the fourth quarter of 2020 at 13.9 per cent year-on-year and averaged 10.1 per cent year-on-year during the two years 2020 Q1 to 2022. The peak rate was close to three times what is appropriate for ensuring 2 per cent inflation. Keeping M4x growth at around 5 per cent p.a. would have entirely avoided the Covid-era inflation.

Moreover, a total failure to acknowledge that money growth played any role at all in creating inflation led Bank staff to fail completely to forecast the inflation (hence all the excuses about exogenous shocks and supply chain problems), and it also led the Bank’s MPC to extend QE asset purchases far beyond any reasonable sell-by date. In the summer of 2021, even after inflation had surged, they extended QE until the end of the year.

Why did the Bank make such catastrophic errors? Basically, because they were focusing on interest rates or on their newly-introduced but nebulous “Monetary and Financial Conditions Index” (MFCI), a statistical construct that the Deputy Governor for Monetary Policy (Ben Broadbent) had brought with him from Goldman Sachs.  Search in the Bank’s quarterly Inflation Report, now rebranded Monetary Policy Report, and you must go back to August 2018 to find any single mention of the quantity of money!

The mandate should therefore be re-drawn (1) to ensure that the Bank does not allow either excess money growth (or inadequate money growth — the mistake that MPC members are currently making) to recur, (2) to ensure that the exchange of letters between the Governor and the Chancellor concentrates on the causes of the underlying price increases and is not limited as at present to a tame description of the recent changes in the components of the CPI, and (3) to impose meaningful sanctions such as dismissal from office if sustained violations of the guardrails in (1) continue for more than a specified period.

Every episode of inflation in postwar Britain has been preceded by rapid money growth. Every slowdown of inflation has been the result of slower money growth. “Inflation is always and everywhere a monetary phenomenon,” as Milton Friedman famously taught us. Yet we have allowed the present generation of central bankers to ignore these fundamental lessons. It is time to bring some order back to the classroom, but it may be too late to affect the Tory party’s hopes of re-election.

John Greenwood

John Greenwood is the founder and Chief Economist of International Monetary Monitor Ltd, and was  Chief Economist at Invesco, based in London, from 1999 to 2021. A pioneer of monetary research in Asia, he was the publisher, editor and lead author of Asian Monetary Monitor, a bi-monthly publication which operated from Hong Kong between 1977 and 1996.

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