Gordon Brown had a surprise in store for Eddie George when he summoned the Governor of the bank of england at a meeting at 11 Downing Street on a Bank Holiday Monday, 25 years ago this week.
For the past two years the new Labor Chancellor had been working on a plan to give Threadneedle Street the right to set interest rates and now he was ready to talk to George about it. The secrecy was complete. The first time the City heard of the idea that it would now be up to the Bank to meet the government’s inflation target was when it announced 24 hours later.
George was accompanied by his private secretary Andrew Bailey, since elevated to governor himself. Bailey was there to see George’s surprise at Brown’s news – but now he has to lead the Bank through its most delicate period since independence. The annual inflation rate is 7% – its highest level in three decades – and is expected to move further away from the official target of 2%. The City expects the Bank to raise borrowing costs at 1% on Thursday – the fourth consecutive time it has raised rates.
Speaking ahead of the quiet period when the Bank is avoiding public pronouncements on the impending interest rate decision, Bailey said no one in Threadneedle Street saw the announcement of Brown’s independence coming.
“It had of course been considered as a concept for a few years – but the idea that the New Labor government would implement it immediately surprised almost everyone, I think,” he said.
Bailey recalled that Brown produced a letter outlining his plans. “Eddie, of course, was very supportive of the decision – and the famous letter is now in the Bank of England museum. Although I admit it is not in pristine condition, as for several weeks after Gordon handed it over, it went around in my briefcase.
Under Brown’s proposal, the Bank had a legal obligation to meet the government’s inflation target. Those responsible for setting interest rates were to be questioned by MPs; the governor would have to write a letter if inflation deviated by more than one percentage point from its target. The chancellor would appoint four outside experts to the Bank’s monetary policy committee, who would set policy with the governor and four other Threadneedle Street insiders.
For the new chancellor, the benefits of the new approach were twofold: the Labor government would receive praise from the financial markets for ceding control of interest rates; and the Treasury would have more time to focus on addressing the UK’s long-standing economic problems.
Labor’s 1997 manifesto remained deliberately vague on the plan, Brown said. “We didn’t want to go to the election saying we would make the Bank independent because the Tories would say interest rates would go up.”
The Bank’s reputation was at its zenith during the first decade of independence. Inflation barely strayed from its target and the economy grew steadily. The MPC needed to do little more than make occasional small changes to interest rates, which peaked at 7.5% in 1998.
This had to change. As the 2007-09 financial crisis drew to a close, the Bank had reduced interest rate at 0.5% – then the lowest in its history – and began the process of money creation known as quantitative easing. A second Great Depression was averted but economic performance remained poor.
Bailey said: “Looking back, it’s clear that long-term structural changes had driven interest rates down for many decades before Lehman’s collapse. These became very apparent after the financial crisis.
Bailey thinks these structural factors – such as demographic shifts and weaker productivity growth – are likely to prove persistent.
Brown said the Bank’s independence has held up well as a concept, but added: “It’s going to be tested in a period of stagflation. We need to let go of the idea that central banks are the only game in town.
Howard Davies, the Bank’s Deputy Governor at Independence and now NatWest Bank Chairman, said the Bank had been too slow to raise rates as inflation rose, but added: we better off than if we hadn’t done this? Yes. On the whole it is rather successful. When this happened, the European Central Bank was created on a super-independent model and the Fed was independent. To say that interest rates would continue to be politically determined would have been a difficult position to maintain.
“I said last July that the Bank should raise rates and if it doesn’t, it should eventually do more. The Bank didn’t want to spoil the party and I can understand that, but a change of direction would have been wise. It’s dangerous to be seen behind the game.
In a speech last year, Mervyn King – governor from 2003 to 2013 – criticized central banks for their King Canut cost of living theory, that inflation will stay low because they “say so”. There had been a decade of sluggish economic growth despite the biggest monetary stimulus the world had ever seen and it was “surely time to recognize that many, if not most, economic problems do not lend themselves to monetary policy solutions.” said King.
Bailey dismissed the idea that the Bank let the inflation genie out of the bottle, but added: “The inflation targeting framework is going through its biggest test yet. But we need this framework now more than ever. »
The governor said Britain’s economy has been rocked by a series of “massive shocks”, which have pushed up energy prices and inflation.
“The MPC simply does not have the tools to offset such a shock on the supply side. This would mean raising interest rates to the point that spending would be so low that the prices of other domestically produced goods and services would fall. This would be detrimental and would go against our mandate to avoid causing excessive volatility in production. But do not doubt for a moment our absolute commitment to bringing inflation back to its target.