Why change the Bank of England’s inflation target?


The role of the Bank of England has continued to evolve since its creation in 1694 to finance a war with France. Its main task today is to control prices, which it has largely succeeded in since it took control of interest rates 25 years ago. But like other central banks, it is now struggling to calibrate policy in response to economic shocks triggered by the pandemic and Russia’s invasion of Ukraine. Inflation in the UK is soaring, leaving an institution long seen as a role model for others facing a credibility crisis.

1. How does the BOE achieve its objectives?

The BOE is responsible for achieving an inflation rate set by the government each year. Currently, that rate is 2% based on the consumer price index, a target it shares with most central banks in advanced economies. If inflation diverges by more than one percentage point in either direction, the bank’s governor must write to the Chancellor of the Exchequer – Britain’s finance minister – explaining why and what the bank will do about it. Its main policy tool is the discount rate, the interest rate it pays to commercial banks that deposit money with the BOE. These banks must generate higher returns than they can earn from risk-free central bank deposits. Thus, when the bank rate increases, the cost of borrowing for consumers and businesses also increases, which restricts the supply of money in the economy and depresses prices. In times of crisis, the BOE may also buy government bonds, a tool known as quantitative easing, to reduce borrowing costs and boost spending. Between 1997 and the eve of the pandemic, inflation averaged 2% per year.

2. How has the role of the BOE changed?

Prior to 1997, rates were set by the Chancellor, with the Governor of the BOE providing advice. A few days after taking office, the Labor government of Tony Blair granted the bank operational independence, a measure intended to protect monetary policy from the risk of political opportunism. The BOE initially targeted an inflation rate of 2.5% based on the retail price index excluding mortgage interest payments. In 2003, the target was moved to 2% based on the CPI. In 2013, the BOE saw its remit change again when George Osborne, the Conservative Chancellor, declared that letting inflation run above target was tolerable if necessary to support growth and jobs. At the time, inflation was approaching 3% and the economy was emerging from the eurozone sovereign debt crisis.

3. What could happen now?

Foreign Secretary Liz Truss, the favorite to succeed Boris Johnson as prime minister, said the UK was facing an unprecedented economic situation and the “business as usual” strategy was not working. The BOE should remain independent, but now is the time to review its mandate, she said. In a recent newspaper article, Truss said the recent surge in commodity-driven inflation had been “exacerbated by monetary policy.” How she would overhaul the current system is unclear. She didn’t say she would scrap inflation targeting, but did mention the possibility of expanding the target to include a measure of money supply or nominal gross domestic product. UK inflation is not out of step with the pressures experienced by other advanced economies, where prices are rising at their fastest pace in decades.

4. Does money supply targeting work?

In the early 1980s, Margaret Thatcher’s government set money supply targets to deal with double-digit inflation. The idea was to reach a certain level of money supply to keep prices stable in the long term, even if it meant higher inflation in the short term. However, the measures measured were volatile and sometimes contradicted other signals about the state of the economy. This led to the downfall of monetary targets in official circles and an unfortunate shift to manipulating exchange rates as a means of anchoring inflation. Proponents of the money supply measure regained some authority after Tim Congdon, who advised Thatcher, predicted the latest peak in inflation very early on after seeing money supply growth increase by 15% at the start of the pandemic.

5. Is the independence of the BOE threatened?

Some analysts have expressed concern that discussions of the BOE’s remit review will once again raise questions about the central bank’s independence from political interference. Any loss of credibility for the BOE could hurt the economy by making monetary policy less predictable, leading investors to demand higher yields for holding UK government debt. The chancellor can change the mandate of the BOE overnight if necessary by sending a letter to the governor. In practice, the government would probably consult formally on the matter to signal its intentions.

• A Bank of England guide to interest rates and how they work.

• The Chancellor who introduced Britain’s first inflation target in 1992 said it would be a mistake to abandon the scheme in favor of a money supply target.

• QuickTakes on post-Brexit London and changes to the US Federal Reserve framework.

• QuickTakes archives on central bank independence and the perils of measuring inflation.

• Bloomberg Opinion’s Marcus Ashworth discusses the BOE’s “doomsday” economic outlook, while Paul J. Davies examines the motivation behind the Brexiteer attacks on the BOE.

• A seasoned British monetarist who was an early prophet of the global inflationary shock speaks out against the economics profession.

• Liz Truss’ inflation-fighting options if she becomes Prime Minister.

More stories like this are available at bloomberg.com

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