By Laurie MacFarlane: Earlier this month the Bank of England celebrated its 25th anniversary of becoming ‘operationally independent’ from the UK government. The move was one of New Labour’s first acts in government in 1997, and was hailed by Tony Blair as “the biggest decision in economic policymaking since the war”.
Underpinning this was a radical idea: that inflation management was a largely technocratic function that could be carved out from political decision-making. Because governments had a natural tendency to over-stimulate their economies, especially around election time, there was always an inherent “inflation bias”. By ceding control over interest rates to an independent entity, Labour wanted to guarantee that monetary policy would no longer be used to serve political ends.
For much of the following quarter-century, it was viewed as a resounding success. Consumer price inflation hovered around the Bank of England’s target of 2 per cent per year, leading many economists to declare runaway inflation as a thing of the past.
Today, however, things look rather different.
With inflation soaring to a 40-year high of 9 per cent this month, the Bank of England is starting to feel the political heat. Earlier this month, Tory MPs launched a scathing attack on the bank for “consistently underestimating the threat of rising inflation”. Last week Andrew Bailey, the bank’s governor, told the House of Commons Treasury Select Committee that the current moment represents “the biggest test of the monetary policy framework for 25 years”.
While it is easy to criticise Bailey for his failure to stem inflation, in reality, the ability of central banks to control prices has always been somewhat exaggerated. The relatively low levels of inflation experienced in the UK throughout the 1990s and 2000s had less to do with central bank wizardry and more to do with something else entirely: globalisation. As James Meadway notes: “It wasn’t the flick of a Treasury pen in London that delivered two decades of low inflation in Britain and across the global north. It was the sweat of a vast, new, underpaid working class in Shenzhen and Dhaka and other rapidly industrialising centres of the global south.”
While central bankers on Threadneedle Street convinced themselves that they had mastered inflation management as a fine art, in reality, it was the growing availability of cheap labour, oil and raw materials that kept prices low. But by mistaking correlation with causation, central bankers became increasingly assured about their magical abilities to control consumer prices (asset prices, on the other hand, are a rather different story).
After playing a pivotal role in rescuing the UK economy, our monetary emperors now find themselves sitting naked on their thrones, powerless to act.
Today, however, the global economy is undergoing a dramatic reconfiguration, and inflationary pressures are no longer acting in lockstep with central banker job descriptions. The Covid-19 pandemic and the war in Ukraine have unleashed successive waves of disruption on global energy markets and supply chains, leaving central banks scrambling to respond. However, a key problem is that interest rates – the main tool that central banks typically use to control inflation – are almost entirely useless when it comes to tackling the current sources of inflation, as Bailey has himself admitted. In practice, tweaking interest rates will do little to cut the price of energy, increase the supply of semiconductor chips or alter the course of the war in Ukraine. “There’s not a lot we can do about 80% of it,” he told the Treasury Select Committee.
This leaves central banks in an unusual position. After playing a pivotal role in rescuing the UK economy from the global financial crisis and the Covid-19 pandemic, our monetary emperors now find themselves sitting naked on their thrones, powerless to act.
The significance of this shouldn’t be understated. Faced with the first serious bout of inflation since becoming an independent central bank, the Bank of England is proving to be almost entirely rudderless. The intellectual foundation upon which central bank independence was founded – that inflation management is a largely technocratic function that can be managed by a single monetary entity – appears to have been built on quicksand.
No doubt aware of the existential crisis staring it in the face, the Bank of England quickly decided that ‘something must be done’. Back in February, Bailey – who earns £575,000 a year – sparked controversy by urging workers to exercise “pay restraint” and sacrifice higher wage demands. Last week he echoed this at the Treasury Select Committee, telling MPs that workers should “think and reflect” before asking for pay rises.
If squeezing wages while inflation skyrockets sounds like a strange solution to the cost of living crisis, that’s because it is. But the Bank of England isn’t particularly concerned about people’s pay packets.
What it is concerned with is bringing inflation down and preventing a so-called ‘wage-price spiral’. One tried and tested way of achieving this is to discipline the wage demands of labour. In practice, this is often disguised using the language of ‘managing expectations’. As Bailey has previously explained, inflation expectations can lead “to companies feeling able to raise prices and employees asking for higher wages, to wage pressure and more persistent inflation”.
Despite acknowledging that companies raising prices can be a key driver of this spiral, to date, Bailey has not called for businesses to restrict price increases or rein in soaring profits. Instead, the governor has repeatedly focused his attention on squeezing real wages, which remain lower today than they were in 2008. In essence, the Bank of England governor is openly arguing that household incomes must be sacrificed to fight inflation so that corporate profits can be maintained. In doing so, the supposedly non-political governor has ventured into the world of distribution, which is supposed to be the preserve of his political paymasters.
In essence, the Bank of England governor is openly arguing that household incomes must be sacrificed to fight inflation so that corporate profits can be maintained
Then, earlier this month, the Bank of England’s monetary policy committee hiked interest rates to 1% – their highest point in 13 years. While expected to do little to curb inflation, the move risks exacerbating the cost of living crisis further by making it even more expensive for households to service their debts. Many economists also worry that raising rates too quickly risks triggering a severe recession.
Why would the bank run this risk under the current circumstances, you might ask? The answer is that it is desperate to maintain its ‘credibility’, a term that has been repeatedly used as a stick to beat the bank with since it became independent.
But when central bankers talk about maintaining ‘credibility’, they are not talking about looking credible to you and me, but to the City of London. Whenever Threadneedle Street fails to toe the line of City analysts, the latter often respond by declaring that the ‘credibility’ of the bank’s independence from government is under threat. “Credibility is not infinite and cannot be taken for granted,” as Michael Saunders, a member of the bank’s monetary policy committee, recently put it.
Seeing the Bank of England side with finance capital over households during a cost of living crisis might seem shocking, but it is not new. Central banks are not – and have never been – apolitical technocrats. Inflation is always political, and since becoming independent the Bank of England has regularly privileged the interests of investors and asset owners over workers. But whereas historically these decisions have been concealed behind a veil of technocratic jargon, the cost of living crisis has brought them into sharp focus. And what people now see is a central bank that seems determined to make the cost of living crisis worse, not better. They see a publicly owned body that is quite clearly not on their side.
None of this is to say that the governments are powerless to fight inflation. But doing so will likely require utilising a much wider range of tools than the Bank of England has available in its armoury, including price controls, industrial policy, competition policy and changes to tax and welfare. This in turn will require coordinated action among a range of government departments and agencies, including energy regulators, competition authorities and finance ministries, as well as central banks.
The Bank of England will always play a vital role in the UK economy: it regulates the financial system, promotes financial stability, manages the payments architecture, and acts as a vital ‘lender of last resort’ when crises arrive. But it can’t fight inflation on its own, and it can never be truly ‘independent’ from political decision making. The sooner we put these myths to bed, the sooner we’ll be able to tackle the crisis in front of us.
Laurie Macfarlane is economics editor at openDemocracy, and a research associate at the UCL Institute for Innovation and Public Purpose.
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