Bank of England to loose independence? A wind to flow over others soon? Why an urgent revamp is necessary?

 

Article's Background

I happened to read an article titled "Jeremy Hunt urged to review Bank of England’s independence" published in an international website " The Telegraph" on 20 April 2024 (read the article here). This article is about a written request of 40 senior Conservative Party lawmakers demanding the UK Chancellor of Exchequer (Finance Minister) for a review of the monetary policy independence of the Bank of England (BOE). The request has given several reasons why the present BOE is not in the interest of the general public.

During the past few decades, almost all country governments have followed the BOE model of central bank monetary policy independence. This independence means that the central bank has the freedom to use its policy instruments to control the inflation at low levels, irrespective of the rest of the economy and government policies. Sri Lanka is the latest (14 September 2023) to this independence list which has already created enormous tensions over the abuse of independence by the central bank Board. Therefore, political leaders who have already started a campaign against the independence might find useful in reading the UK's request stated above.

Therefore, this article is to highlight the background and irrationality of the beleaguered independence in the current context of macroeconomic globality.

Emergence of central banks and monetary policy 

The BOE is the first central bank that operated as the lead commercial bank in the capacity of the bankers' bank with the state license. Later, it was given the autonomy to carry on banking on the monopoly of national currency printed by it on behalf of the government. Recently, the BOE apologized for its financing associated with slavery trade in its early period as a commercial bank.

Early central banks were established to unify currencies with a legal tender and to operate as bankers' banks and clearing house for the objective of maintaining financial/banking system stability. In that time, financial/banking crises happened due to multiple currencies issued by commercial banks as and when the public lost the trust in currencies issued by some banks. Therefore, the monetary policy at that time was the provision of liquidity or loans to banks in order to support economic activities taking place akin to banks. As such, interest rates and money printing/lending operations of central banks until 1980s were confidential operations known to commercial banks only. Further, Further, they were operated as part of or supporting the broader economic policy of the contemporary governments.

Later with the increasing monetarization of economies through the legal tender/sovereign currencies, central banks commenced the conduct of the monetary policy for economic stability objectives with greater transparency and periodical public communications. Accordingly, setting of central bank interest rates for lending to banks became the key policy instrument announced to the public from time to time. Therefore, money printing was primarily linked to interest rates policy of central bank. In extraordinary economic times, central banks also operated special loan schemes through money printing at concessionary interest rates.

Later, central banks were influenced by monetarists who argued that general prices and inflation are a result of the amount of money circulating in the country. Therefore, central banks in developed countries commenced the use of interest rates to regulate the money stock for the undisclosed target or control of inflation. This was presented as the monetary policy for price stability. As a result, they tended to separate the monetary policy from the fiscal policy so that monetary policy is a good internal control system of the government for the price stability policy while the fiscal policy was free to carry out political agendas of elected governments. It is this approach that is pursued at present for monetary independence of central banks.

1997 BOE independent model and its collapse in 2007

The new approach was the legally recognized model of BOE independence for monetary policy introduced in 1997. The model involved in four elements.

• Transfer of bank supervision/regulation function from BOE to Financial Services Authority (FSA).

• Setting up the monetary policy committee (MPC) in the BOE to decide on interest rate or Bank Rate (or base rate) paid to banks for their overnight deposit balances at the BOE.

• The government prescribing the inflation target for the BOE monetary policy.

• The government reimbursing the cost incurred by the BOE in monetary operations carried out to stabilize market interest rates.

• Setting up a tripartite committee of BOE, FSA and Treasury to take special policy decisions on financial stability where the BOE undertook relevant research.

Accordingly, this was the UK's new governance system for regulation of the financial system through division of responsibilities.

Many countries followed this independent monetary policy model in line with BOE and monetarist recommendation for central banks to act on taming inflation. The new system contains an independent MPC set up in law, a pre-announced inflation target for the conduct of the monetary policy and the decision of central bank interest rate by the MPC based on inflation trends and forecasts. Accordingly, fiscal policy requirements such as borrowing at low cost are not considered in the monetary policy.

However, the US followed its own model of central banking (Fed) with both monetary policy and bank supervision for broader macroeconomic objectives of stable prices, maximum employment and moderate long-term interest rates in the interest of promoting and safeguarding the real sector. Instead of specific MPC, the Federal Open Market Operation Committee (FOMC) consisting of members of the Fed decides on Fed's interest rates and money printing operations in consideration of Fed's multiple mandates.

However, just in 10 years the UK model miserably failed with the onset of the financial crisis in September 2007 in the US and Europe. The run on Northern Rock bank was the trigger in the UK. As the bank supervision had been taken out from the BOE, there was a confusion as to who is responsible for preventing bank runs. Therefore, after the run on Northern Rock was spread across the country, the BOE had to provide the lender of last resorts (LOLR) as a part of national policy decision to the Northern Rock and other banks for rescue operations whereas the government had to nationalize banks to rebuild the public trust.

Northern Rock moment of BOE rescue, 19 September 2007 

(Source Financial Times)

As a result, under the post-financial crisis system reform in 2012, the prudential supervision of banks and shadow banks was given back to the BOE through a new subsidiary "Prudential Regulatory Authority" (PRA) established under the BOE while the consumer protection/fair market supervision was vested with Financial Conduct Authority (FCA) established from the FSA. Accordingly, Financial Policy Committee (FPC) was set up in the BOE parallel to the MPC to decide on specific regulatory policies for financial stability issues.

Meanwhile, the MPC and monetary policy framework labelled as inflation targeting monetary policy continued as before. It is this new but tainted or dirty independence that has come under attack at present. However, no one seems to complain about the BOE independence in handling supervision.

Inflation targeting monetary policy was introduced to developing countries by the IMF/World Bank in 1990s and 2000s under their financial and technical assistance programmes. Some developing countries have now rebranded it as flexible inflation targeting so as to follow the monetary policy for a desirable balance between price stability and economic growth.

Key feature of the independence

It empowers the central bank to act on interest rates and money printing focusing on the inflation target (2% at present in developed countries), irrespective of impacts it will have on the economy. For example, in the case of monetary policy tightening (raising interest rates), the central bank does not care whether firms become bankrupt, unemployment rises, investments fall and budget deficit and debt rise due to higher interest cost and economy and living standards collapse.

Instead, the central bank only looks at annual increase of the consumer price index (or inflation rate) each month and keeps on raising interest rates until the inflation rate or the annual growth of the consumer price index on average is around the inflation target.

As the central bank is not aware of any formula for its interest rate to achieve the inflation target, given externalities on the economy, it gradually changes the interest rate during several years until it is satisfied that the actual inflation is on track towards the target. For example, the BOE has raised the interest rate 14 times so far for a total increase of 5.15% from November 2021 (i.e., from 0.10% to 5.25%). However, inflation has not firmly reached the target of 2% as yet. The case is same for many central banks including the Fed and European Central Bank.

Four key hypotheses running monetary policy

The process of monetary policy is based on four main hypotheses which are highly debatable on empirical grounds.

• Inflation is always a result of the monetary expansion beyond the growth of the real economy. This implies that the higher monetary expansion fuels the demand for goods and services than the supply causing price increases in general. The deflation is the opposite story. This hypothesis is known as the quantity theory of money, a mathematical view first introduced in 7th century. Therefore, the monetary policy uses interest rates to affect credit and the monetary expansion to control inflation.

• The trade-off exists between inflation and unemployment though wages. For example, if employment rises, the resulting increase in wage income causes higher demand and inflation. This is known as Phillip curve introduced in 1958. Accordingly, the monetary policy uses interest rates to affect the demand, production and employment looking for a preferred level of inflation. Therefore, central banks look for a balance between inflation and unemployment on the Phillip curve version of the inflation and unemployment.

• The transmission of effects of interest rates on credit, demand, production, employment and inflation takes years of lags until the inflation reaches the target. Therefore, this transmission is believed to take place through interest sensitive demand sectors of the economy.

• Monetary policy is able to anchor inflation expectations of the public towards the target. As the main cause of inflation is the inflation expectations that get translated into future wage and price settings, the monetary policy is expected to revere such expectations towards the inflation target over time. This is the hypothesis of inflation anchoring by the monetary policy.

Accordingly, all public communications rest on conceptual explanations as to how interest rates will dive the economy for price stability through hypotheses stated above. The policy performance story is supported by the actual trend of inflation and statistically computed inflation forecasts.

Current concerns that have led to question the independence

The present regime of high interest rates and adverse effects on economies world over have caused serious public concerns and doubts over central bank independence in advanced market economies. Major sources of concerns are listed below.

• Significant increase in the cost of house mortgage and consumer credit that has reduced households income available for other living expenses. This has caused significant erosion of livings standards and savings and social tensions.

• Rising budget deficit due to high interest cost on rollover/refinancing of debt where fears are rising over future tax hikes to meet rising debt service payments. It is reported that the average interest cost on US federal debt stock (US$ 31 trillion at present) has risen so far to 3.05% from 1.57% in February 2022 whereas interest cost in proportion to tax revenue has risen to 35.7% from 24.3%. The US new debt is raised at interest rates of 4%-5% at present as compared to below 1% during the Pandemic time in 2020. One can imagine how Sri Lanka got into the chronic bankruptcy when yield rates of government securities were pushed arbitrarily by the central bank to around 30% in 2022 from their levels of 5%-8% in 2021. 

• Although a significant disinflation towards 2% inflation target has been noticed, central banks are not seen ready yet to start cutting interest rates as they do not see the full confidence in sustainability of the present disinflation path. The reason is the rising GDP and wage growth with historically low unemployment rates which are not considered favourable for cutting interest rates in view of the treasured hypothesis of inflation-unemployment trade-off.

• In the UK, there is a complaint among some Conservative Party Parliamentarians that the collapse of Liz Truss government in 49 days over the mini-budget for tax-cut based growth at the end of 2022 has been largely assisted by the BOE acting in concert with financial markets by predicting increased borrowing and higher interest rates. Liz Truss government had to step down to avert the financial market turmoil (Read an article here).

Overall, a wide resistance is growing against continued high interest rates despite the significant disinflation path observed in the past year. However, some economists tend to believe that the prevailing disinflation is largely a result of the gradual recovery of the supply chains disrupted by the Pandemic and war in Ukraine and, therefore, high interest rates are only another source of disruption to supply chains as central banks never had policy experience in dealing with global Pandemics. This view is largely based on strong growth, employment and wages that continue to prevail despite high interest rates and underlying hypotheses. 

Action to save the humanity from central banks

In view of the background presented as above, serious concerns are being raised world-wide whether monetary policy independence now is in the interest of humanity of the modern era. Some of key concerns are listed blow.

• The main reason is the bureaucratic manner in which the monetary policy independence is pursued for so-called price stability without any empirical evidence whether central banks have an undisputed ability to control inflation at targets as advocated by old monetarists.

• The key driver of monetary policy is the inflation forecast made by statistical models used by central banks. On this ground, central banks call them data dependent and futuristic like divine human. The BOE is longest serving forecaster of inflation for decades. However, the study made by Princeton Economics Professor Ben Bernanke, a former Fed Chairman for two terms, has proved the model's inappropriateness. The BOE has accepted its findings and recommendations. Similar concerns have now been raised on the inflation forecasting model of the Fed too. In that context, independent monetary policy has lost the public trust in its basic mechanism.

• Given the dynamism in the price mechanism operative in modern market economies, the ability of central bank interest rates (mostly overnight rates) as a single instrument to control prices and inflation at preferred targets is a myth as four hypotheses underlying policy operations as stated above are not supported by real world data. In fact, it is the role of fiscal policy and supply side markets that are quite dominant on prices where interest rate is only one factor affecting the cost side of the economy.

• It is now believed that economy is less sensitive to interest rates where interest cost is passed on to the price structure causing cost-pushed inflation. This is the reason why inflation doesn't respond to the monetary policy as expected and central banks wait years to see the effects. In fact, one mandate of the Fed is to maintain moderate long-term interest rates because of this cost factor-based competitiveness.

• The significant volatility caused on public finance and living standards without any certainty of the outcome on price stability or inflation is a fundamental concern.

• In modern market economies, money is also an economic resource like other resources produced by markets to support the production drive. Government deficit finance through debt and banking business are the major producers of monetary resources to activate production activities. Therefore, central bank money and interest rates are only trivial operations in money markets to provide reserves of sovereign currency required in a fraction to support the market supply of monetary resources. It is especially required because central banks operate payments and settlements systems. Therefore, a magical role of price stability by independent monetary policy is only tribal myth.

• Significant abuses of independence also have been reported from several central banks. For instance, the unethical and unlawful wage hike granted by the Central Bank of Sri Lanka for its employees no sooner the independence was given is now under the investigation by the Parliament. Reports are available from several central banks on insider dealings in monetary operations to support profits of friendly dealers as monetary operations are hardly audited in view of the independence.

Some Remarks

Overall, the inhuman way of the conduct of independent monetary policy is seen as the basis for the UK's demand for the review of the independence. Therefore, the demand is equally valid for other central banks too who do not coordinate monetary policies on the national front for the benefit of the general public. 

Therefore, the proposed review is about the integration of the monetary regulation arm of the governments (now outsourced to the central banks) within the broader national policy framework where the elected governments will take the responsibility for the national policy front.

This requires governments to ensure that monetary resources are produced and supplied through a range of credit/financial products with different risks that can facilitate business innovations and improvements in living standards with humanity of the modern world. This is mostly required in low income countries like Sri Lanka which lack market development and quality living standards even after decades of political independence.

As most lawmakers are good businessmen who know the economic and business side of money and finance, they should be able to disregard monetary hypotheses and understand the common sense of the demand, supply and prices of money and its role on modern living standards and humanity for which they are accountable in the country governance inclusive of the Constitution. 

Instead, if they are willing to give the independence to the central bank because few persons want it to run as they wish to keep hypothetical price stability, it will be the worst inhumanity they incur in this century.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures. All are personal views of the author based on his research in the subject of Economics which have no intension to personally or maliciously discredit characters of any individuals.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 12 Economics and Banking Books and a large number of articles published.