Howard Davies - The Chancellors

In spite of these criticisms, the main architecture of monetary policymaking remained intact throughout the period. The original inflation target was set at 2.5% plus or minus 1%. The target was therefore symmetrical, unlike the target the ECB set for itself, of maintaining inflation below but close to 2%. There are strong arguments for a symmetrical target.

The significance of the range was that if inflation moved outside it, on the upside, or the down, the Governor should write an open letter to the Chancellor explaining why and what would be done to return to the target. For many years, the Governor’s pen remained capped, causing Mervyn King, in office from 2003 to 2013, to quip that the art of letter-writing was dead. After the financial crisis, letter-writing came back into vogue. But in structural terms, the changes since 1997 have been relatively minor. In December 2003 the centre of the target range was moved down to 2%, when the basis of measurement was changed from the Retail Prices Index (RPI) to the Consumer Prices Index (CPI). The Bank has, since 2010, maintained inflation at an average very close to the target, while the ECB has been well below. The symmetrical target may be partly responsible for that difference. In 2021 the ECB acknowledged that criticism by shifting to a symmetrical approach. 2

A potentially more significant change, at the end of the period, was the insertion into the Bank’s mandate of a reference to climate change. In March 2021, Chancellor Sunak reaffirmed the 2% target, but said that monetary policy should ‘also reflect the importance of environmental sustainability and the transition to net zero’. 3The Bank responded that it would change its approach to corporate bond-buying ‘to account for the climate impact of the issuers of the bonds we hold’. There will also be implications for banking supervision. Since at least 2017, when the Network for Greening the Financial System was created, a number of European central banks have been seeking to incorporate climate goals into their monetary and supervisory policies. That has been controversial, with some commentators arguing that an activist approach to climate change would put their independence at risk. At an ECB conference in November 2020, John Cochrane of the Hoover Institution at Stanford argued: ‘This will end badly. Not because these policies are wrong, but because they are intensely political, and they make a mockery of the central bank’s limited mandates.’ 4The Bank of England is less exposed to that risk, but Sunak’s rather vague formulation puts a heavy burden on the Governor’s shoulders. Mervyn King sees risks for the Bank’s independence: ‘Central banks’ increasing focus on climate change is particularly odd … Most important, the central banks’ new and broader ambitions have profound implications for their independence.’ 5

How did Bank independence affect the Treasury? The staffing implications were minor. The Treasury team of officials and economists preparing interest rate advice was small, and already depended heavily on the Bank of England for market intelligence. There is a Treasury observer on the MPC, who needs to be briefed, but he or she is genuinely an observer, except on fiscal policy where the individual may offer a view on the likely fiscal stance. There is certainly no equality of arms on monetary policy between the two institutions, or indeed on macroeconomic policy more generally. As Gus O’Donnell points out, the Bank employs far more economists than the Treasury, and in the Treasury those in the macroeconomic area ‘are typically young and lacking in experience. There is an advantage, though. Younger staff have been trained more recently, and are not slaves to some defunct economist.’ 6

When the change was made, it was widely assumed that Brown would find it hard to restrain himself from commenting on interest rates. That assumption turned out to be incorrect. Brown was scrupulous in avoiding public comment on the Bank’s policy, whether in Parliament or elsewhere, and his successors have adopted the same self-denying ordinance. We cannot be sure that in their regular lunches the Chancellor and the Governor do not discuss upcoming decisions, but there is no evidence of any attempt to exert inappropriate influence, which – given the voting structure – would in any event be unlikely to have a decisive impact. The Treasury also stopped its previous practice of censoring, or as it used to put it, ‘offering helpful drafting suggestions’ on, the Bank’s publications. There are more examples of Governors commenting on fiscal policy, which is equally inconsistent with the 1997 division of responsibilities. That created tension, between Alistair Darling and Mervyn King in particular. But for the most part the new arrangements worked well. The implicit assumption was that were a loose fiscal policy to threaten to generate inflation above the target, the Bank would react with a rise in interest rates. There was no particular need for active coordination of fiscal and monetary policy. In the meantime, the Treasury benefited from lower long-term gilt rates. For a long time, the British government had paid around 150 basis points more than the German government for its long-term borrowing. That spread narrowed rapidly after Bank independence promised tighter control of inflation in the future.

For a decade this new dispensation caused few problems, though stocking and restocking the MPC was sometimes a challenge. The Treasury has found it particularly difficult to maintain an appropriate gender balance, for which it has attracted criticism. There were lively arguments about the resources the independent members had at their disposal. MPC members also thought the committee met too often: the number of meetings was specified in the legislation, and was later reduced from twelve to eight. But in other respects the new system, even though it had been legislated in haste, has proved remarkably robust.

Signs of strain began to emerge, however, in the financial crisis of 2008/9. When interest rate reductions failed to provide enough stimulus to economic activity, the adoption of quantitative easing (QE) muddied the monetary and fiscal waters. 7The arguments were expressed most forcefully on the other side of the Atlantic. Charles Plosser, former President of the Federal Reserve Bank of Philadelphia, argued that ‘a large Fed balance sheet that is untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed and use its balance sheet to conduct off-budget fiscal policy and credit allocation’. 8

In the UK the potential for confusion about the objectives of policy and the transmission mechanisms of new monetary instruments was offset to some extent by a process of formal approval for QE by the Treasury. So Alistair Darling, in January 2009, authorized the Bank of England to create a new fund called the Asset Purchase Facility, which the MPC could use for the purchase of gilts and corporate bonds. The total amount that can be purchased is set by the Chancellor after a request from the Governor. The initial request was for a ceiling of £150 billion, but there have been successive further increases. By March 2021, the Bank held £875 billion of gilt-edged stock alone.

Formally, the Bank cannot buy gilts directly from the government. That would conflict with the ‘no monetary financing’ rule. But as the volume of purchases grew in the Covid crisis, the distinction became much less clear. Market participants were well aware that the central bank would hoover up the debt they had bought at auction. The Bank became the purchaser of first resort rather than the lender of last resort. In 2021 the Bank owned more than half of all gilts in issue. And the government’s overdraft facility at the Bank, known as the Ways and Means account, was extended without limit. 9