Why the Bank of England needs a monetary framework review to keep policy at the frontier

The Bank of England has built an enviable reputation as a central bank at the forefront of modern policymaking. This was demonstrated yet again as the Covid crisis unfolded, with coordinated monetary, macroprudential and microprudential actions alongside fiscal measures that the IMF described as “one of the best examples of coordinated action globally”.

The results speak for themselves. Prior to the pandemic, the UK stood out among its G7 peers, delivering well-anchored inflation expectations, low unemployment against a backdrop of high and rising labour force participation, and solid growth.

But in the face of mounting challenges, not least due to post-Brexit as well as Covid economic realities, there is a risk that the Bank of England could fall behind its peers. Unlike the US Federal Reserve and the European Central Bank, the Bank of England’s mandate is much narrower and does not allow for a review of its goals and how they might best be achieved, as this would require an endorsement from Her Majesty’s Treasury.

The occasion of the annual exchange of monetary policy remit letters between the Chancellor of the Exchequer and the governor of the Bank of England, in which the Treasury specifies the definition of price stability and the government’s economic policy objectives, provides a timely opportunity to do so. Such a review could potentially cover three key areas.

First, a consideration of the objective of monetary policy, if only to reaffirm that the optimal allocation of resources is best achieved through the pursuit of price stability. The benefit, however, would be to reinforce the importance of an independent, delegated authority whose objectives are fully aligned with those of an elected government.

This is particularly important given the UK’s ambition to achieve net-zero emissions by 2050, which will probably require a vast redistribution of assets towards clean energy. Many have bristled against climate-change objectives for central banks, but the fact of the matter is that, in a free society, delegated authorities must be structured in such a way that facilitates government — and their citizens’ — objectives. If they are not, this is the surest path to eroding their credibility and independence.

Second, a review should consider how best to interpret price stability. The Fed — and possibly the ECB later this year — is now willing to tolerate temporarily higher inflation, which could put the UK at a distinct disadvantage in terms of international competitiveness just as it desires to build up new markets abroad. Moreover, the dual challenges of Brexit and Covid will probably require a sustained commitment to supportive monetary policy as the UK economy regains its growth potential. Achieving this under the current regime could prove challenging. For example, a nominal GDP target is better suited to adapt to changes in underlying real growth: When growth is weak, inflation can be somewhat higher while achieving the target. But as real growth picks up, inflation needs to be brought down. In light of the UK’s circumstances, a serious review of such alternatives seems to be in order.

Third, there should be a commitment to regularise such reviews, as is the case for example in Canada. Doing so would take the political heat out of them and also normalise them, avoiding the awkward impression — and the associated uncertainty — of an ad hoc review that things are going badly wrong. The experience of the past few years has demonstrated that broader framework reviews should be part and parcel of a modern central bank incentivised to adapt its structure in order to best meet the needs of the people it serves.

For the UK, such a review could be carried out by the central bank, with input from the government and an impartial expert committee, as for example in Sweden and Norway. This would allow for a fuller assessment of the mandate as well as a review of its strategy and the tools to achieve those goals.

Since crashing out of the European Exchange Rate Mechanism in 1992, the Bank of England has built a reputation over the years as a highly respected central bank that is regarded as “best in class’” In light of the major economic challenges facing the UK, a review is now needed to ensure it stays there.

Katharine Neiss is chief European economist at PGIM Fixed Income.

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