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Central bank independence is on the decline

A decade ago, respect for central bankers peaked. With three words, Mario Draghi’s commitment to do “whatever it takes” ended the eurozone crisis and demonstrated the value of strong, independent institutions. Credible statements from trusted policymakers work wonders. But Draghi’s intervention as European Central Bank chief was the high watermark.

Donald Trump complained repeatedly that the Federal Reserve’s interest rate rises between 2017 and 2019 were undermining his economic success. Describing Fed chair Jay Powell as an “enemy” of the US and his colleagues as “boneheads” were just two of many insults the former president hurled.

After Trump came President Recep Tayyip Erdoğan of Turkey. He handpicked Şahap Kavcioğlu in early 2021 to be a central bank governor who could finally be counted upon to implement the president’s unorthodox idea that lower interest rates reduce inflation.

Now, with UK inflation heading to double digits, Liz Truss, the frontrunner to become the next prime minister, has pledged to review the Bank of England’s independence. Her allies, such as the likely next chancellor Kwasi Kwarteng, have made implicit threats, saying, “We need to look at what went wrong”.

It would be simple to present Trump and Erdoğan as cautionary tales for Truss. Powell ignored Trump’s bullying. Rightly so because, a few years on, we know the Fed’s core mistake was to tolerate too low interest rates for too long, amplifying inflation. Turkey, which cut rates on Erdoğan’s orders, now suffers an official inflation rate of 79.6 per cent in July, with many economists thinking the true rate is even higher.

This inference would, however, be wrong. Many of Truss and Kwarteng’s economic positions are bizarre, but they are correct in their diagnosis that something has gone wrong at the BoE. Of course, high energy prices have contributed much to the surge in inflation, but the UK suffers from the worst of all worlds — having the US disease of excess demand, a UK-specific drop in labour supply that the BoE failed to notice, firms that feel comfortable in raising prices and workers determined to protect their wages. It is no wonder inflation is marching up to 13 per cent.

When trying to defend the BoE’s independence in this environment, its governor Andrew Bailey has a problem. The traditional argument is to say that if independence were loosened, all hell would break loose and the UK would return to the high inflation of the 1970s. That has already happened.

Without that card, the BoE has resorted to the risky strategy of blaming others and insisting it has made no mistakes. According to Bailey, the BoE is also a victim of high inflation and it could not have foreseen Russia’s invasion of Ukraine and the resulting rise in natural gas prices. “We don’t make policy with the benefit of hindsight,” Bailey likes to say.

For those who want to protect valuable economic institutions such as the BoE, the governor’s position is impossible to support. Hindsight is valuable. It allows us to learn lessons. In any case, Bailey did not need hindsight, he just needed to listen to his chief economist in February 2021, who warned that the “greater risk at present is of central bank complacency allowing the inflationary (big) cat out of the bag”.

Instead, Bailey is falling into the trap described by Professor Ricardo Reis of the London School of Economics of blaming the rain for getting wet even though he was holding an umbrella. As Reis said, when you have a target of 2 per cent, inflation rates of more than 7 per cent for well over a year is almost always the central bank’s fault.

The new prime minister and chancellor will be fully entitled therefore to review the central bank’s mandate. I think it is unlikely they would want to change the legal requirement of the BoE to “maintain price stability” or to use the Treasury’s reserve powers to direct the central bank’s Monetary Policy Committee.

Instead, Truss might want to give the BoE a new definition of price stability. She has hinted that she is interested in a nominal gross domestic product target. Since this also rose at an annual rate of 9.1 per cent in the second quarter, it would not make a lot of difference.

But Truss and Kwarteng could act perfectly within the boundaries of the BoE’s operational independence to sharpen its incentives. They could amplify the importance of inflation control in the annual letter the chancellor writes to set the BoE’s inflation target.

Even better, Kwarteng could write a more pointed reply to the BoE when it next has to explain an inflation deviation of more than 1 percentage point from the target. Traditionally, the BoE says that something outside its control has occurred and that it has already taken action to correct matters. The chancellor then replies with a supine acceptance of the central bank’s arguments. Instead, the chancellor’s letter should become a proper means of challenge and accountability for the BoE.

While it might bruise the egos of some senior BoE officials, it would in no way send the UK down the dangerous paths of Trump or Turkey. Central bankers should welcome the additional shackles. Too much freedom and too little accountability for unelected officials is unhealthy in a democracy.

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