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Central bank independence is on the decline

Ten years ago, respect for central bankers peaked. In three words, Mario Draghi’s commitment to “do everything” put an end to the eurozone crisis and demonstrated the value of strong, independent institutions. Credible statements from trusted policymakers work wonders. But Draghi’s intervention as head of the European Central Bank was the highlight.

Donald Trump repeatedly complained that the Federal Reserve’s rate hikes between 2017 and 2019 undermined his economic success. Describing Fed Chairman Jay Powell as an “enemy” of the US and his colleagues as “bruises” were just two of the many insults the former president threw.

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

With inflation in the UK approaching double digits, Liz Truss, the frontrunner to become the next prime minister, has pledged to review the independence of the Bank of England. Her allies, such as the likely next Chancellor Kwasi Kwarteng, have implicitly hazardssaying “We need to look at what went wrong”.

It would be easy to present Trump and Erdoğan as cautionary tales for Truss. Powell ignored Trump’s bullying. Rightly so, because a few years later we know that the Fed’s biggest mistake was to tolerate too low interest rates for too long, fueling inflation. Turkey, which cut tariffs on Erdoğan’s orders, now faces official inflation of 79.6 percent in July, with many economists thinking the actual rate is even higher.

However, this inference would be incorrect. Many of Truss and Kwarteng’s economic views are outlandish, but they are right in diagnosing that something has gone wrong at the BoE. Of course, high energy prices have contributed much to the rise in inflation, but the UK is suffering the worst of all worlds – with the US over-demand disease, a UK-specific decline in labor supply that the BoE has failed to notice, companies feel comfortable raising prices and workers determined to protect their wages. It’s no wonder that inflation is rising to 13 percent.

In defending the BoE’s independence in this environment, Governor Andrew Bailey has a problem. The traditional argument is that if independence were relaxed, 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 made no mistakes. According to Bailey, the BoE is also a victim of high inflation and could not have foreseen the Russian 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 like the BoE, the governor’s position is impossible to support. In retrospect is valuable. It allows us to learn lessons. At least Bailey didn’t need to look back, he just had to… listen to his chief economist in February 2021, who warned that “the bigger risk right now is that central bank complacency will let the inflationary (big) cat out of the bag”.

Instead, Bailey falls into the trap described by Professor Ricardo Reis of the London School of Economics by blaming the rain for getting wet even though he was holding an umbrella. As Journey saidif you set a 2 percent target, inflation above 7 percent for well over a year is almost always the fault of the central bank.

The new prime minister and chancellor will therefore have every right to review the central bank’s mandate. I think it’s unlikely they would want to change the BoE’s legal requirement to “maintain price stability” or leverage the Treasury’s reserve powers directing the central bank’s Monetary Policy Committee.

Instead, Truss could give the BoE a new definition of price stability. She has hinted that she is interested in a nominal gross domestic product target. Given that it also rose 9.1 percent year-on-year in the second quarter, it wouldn’t make much of a difference.

But Truss and Kwarteng could perfectly act within the bounds of the BoE’s operational independence to tighten its incentives. They could reinforce the importance of controlling inflation in the chancellor’s annual letter to set the BoE’s inflation target.

In fact, Kwarteng could write a sharper response to the BoE the next time it has to explain an inflation deviation of more than 1 percentage point from the target. Traditionally, the BoE says that something beyond its control has happened and that it has already taken action to correct things. 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 challenging the BoE and holding it accountable.

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

chris.giles@ft.com

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