Making an independent Bank of England work better Contents

Summary

The Bank of England Act 1998, which provides the legal framework for the Bank’s operational independence, was passed 25 years ago. By removing political control over monetary policy, operational independence was seen as a means of strengthening economic confidence in the UK economy. In view of recent economic volatility, and to mark the 25th anniversary of independence, we consider it to be an appropriate time to review the operation of that framework with respect to the conduct of monetary policy.

For much of the past 25 years, the enhanced credibility of monetary policy brought about by independence has contributed to a low inflation environment. The absence of political interference is seen by many as a major component of stable inflation expectations. While external factors, such as globalisation, have contributed to favourable conditions throughout this period, the majority of our witnesses were clear that independence has been a significant factor in promoting price stability. It is our strong view that independence should be preserved.

However, while independence is an important instrument in achieving price stability, it is clear that the framework for operational independence is now being tested. Confidence in the Bank is critical if it is to preserve its independence. Yet public confidence in the Bank of England has fallen dramatically as inflation has remained well above the Bank’s target over the last two years.

High and persistent inflation since 2021 is in part due to supply shocks brought about by the COVID-19 pandemic and Russia’s invasion of Ukraine. Nonetheless, the persistence of above-target inflation over this period also reflects errors in the conduct of monetary policy, including an over-reliance on inadequate forecasting models. We do acknowledge that the Bank of England is not the only central bank that failed to anticipate high and persistent inflation. This may be partly explained by a sense of complacency about inflation among all major central banks given the prevalence of low-price pressures over the last decade or so. We received evidence that errors in monetary policy reflected a lack of diversity of view in the Bank of England and wider central bank community. When inflation rose, central bankers focused on supply-side shocks as the cause, and the higher inflation rate was seen as transitory. Some witnesses therefore considered that the inflationary potential of elevated rates of money supply growth were given insufficient attention by the Bank.

Given this, we have identified several key issues which need to be addressed so as to improve the Bank’s performance, and thereby restore confidence in the Bank.

First, in order to safeguard economic and financial stability, we recommend that the interaction between fiscal and monetary policy requires clear lines of responsibility and effective communication between the Bank and His Majesty’s (HM) Treasury. This is especially the case when interest rates fall towards their lower bound. Moreover, the repeated use of quantitative easing has had implications for the Bank’s balance sheet and, consequently, for perceptions of the Bank’s independence. To address this, we recommend that the Bank and the Debt Management Office publish a memorandum of understanding which clarifies how the interaction between monetary policy and debt management should operate. The Bank should also give prominence to the study and reporting of the potential economic risks arising from the expansion of its balance sheet due to an extended quantitative easing policy. We also repeat our call for the ‘Deed of Indemnity’ to be published—the contractual document between HM Treasury and the Bank, which commits the taxpayer to paying any financial losses suffered by the Bank which might result from the quantitative easing programme.

Second, witnesses often expressed concern regarding the Bank’s expanding remit, especially with respect to the matters it is expected to have regard to or consider—climate change being the most cited example—to support the Government’s economic policy. We found that this widening of the Bank’s remit risks jeopardising the Bank’s ability to prioritise its primary objectives; risks drawing the Bank into the Government’s wider policy agenda; and increases the potential for conflict between its objectives. We recommend that the Bank’s remit should be pruned by HM Treasury, with a focus on the number of matters it is expected to have regard to and consider. The Bank’s management structure, which has expanded in line with its growing remit, should also be reviewed with a focus on whether it could be made more streamlined.

Third, errors were made in the conduct of monetary policy by the wider central banking community, including the Bank of England. To address this, the Bank must do more to foster a diversity of views and strengthen a culture that encourages challenge. Areas that need attention include governance, hiring practices and appointments, especially to the Monetary Policy Committee. We welcome a recently announced review, to be led externally by Dr Ben Bernanke, into the Bank’s forecasting capability. We hope this will address shortcomings in the Bank’s modelling and forecasts.

Finally, and critically, an independent Bank of England must be held to account effectively. A small group of appointed Bank officials, who are not part of the elected Government, exercise significant powers which have an impact on the entire UK economy. Given that the Government is unable to challenge the Bank’s decisions without compromising its independence, it is therefore imperative that the Bank and its remit are effectively scrutinised by, and its officials are held accountable to, Parliament. As the Bank’s remit has grown, there has not been a commensurate increase in scrutiny or the means to hold those officials to account. We are concerned that a democratic deficit has emerged, which risks undermining confidence in the Bank and its operational independence. We therefore believe that current Parliamentary arrangements should be enhanced. In particular, we recommend that Parliament should conduct an overarching review of the Bank’s remit, performance and operations. Such a review, conducted every five years, would enhance Parliament’s ability to hold the Bank to account and to express its view on the Bank’s performance and leadership. More scrutiny and accountability should strengthen confidence in operational independence.





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