It is, for the Bank of England, Independence Day. Just five years ago the Bank of England was given its freedom to set monetary policy. It was a decision, taken in those very first days of the new Labour government, that has been widely applauded – perhaps more so than any other economic decision it has taken.
In fact the Bank's stewardship has been so acclaimed that one of the arguments for not joining the euro would be abandoning a good mechanism for determining interest rates for a worse one.
This is an astonishing turnabout. British post-war monetary policy prior to 1997 had not been widely admired. Interest rates were set by the Chancellor, and while this was notionally on the advice of the Bank an element of political manipulation sadly crept in. Chancellors, being politicians, were expected to deliver conditions that would win elections and so tried to create pre-election booms.
They did not, of course, invariably succeed – in 1992 John Major had to fight an election at the bottom of the economic cycle. In addition, part of any instability in British economic policy was down to errors of fiscal policy, not monetary policy. But enough damage was done to give Britain a more pronounced economic cycle than that of most other large developed nations, as well as significantly higher inflation than either Germany and the US.
The better performance of the Bundesbank and the Federal Reserve, both of which had freedom to set interest rates, was one of the key reasons behind the general movement towards giving central banks more power during the 1990s. In the case of the Bank, however, this was coupled with the separation of one other power, the power to regulate the financial system. This was devolved to the Securities and Investments Board, now the Financial Services Authority.
So the Bank has gained freedom in two ways: it has the freedom to set interest rates but it also has the freedom not to have to worry directly about financial market regulation. Many people within the Bank, including Eddie George as he then was, did not like the loss of the regulatory role. But with hindsight it has been a blessing. Not only does the Bank not catch the flak for financial failings; it can focus on the even more important task of monetary policy.
The model – a mixture of outsides seconded to the Bank and insiders – had to be different from the Bundesbank and Fed models, both of which are based on a federal system. But it is similar to those models in that the primus inter pares is the chairman, in this case the Governor.
So how has it done? Well, have a look at the graphs. Independence came in mid-1997, though the graphs go back to the beginning of 1996. For a start, the Bank has been remarkably successful in curbing inflation. After the peak in 1998, "headline" inflation has come down to lower levels than either the US or the eurozone – but without overcooking the anti-inflation policy as has the Bank of Japan. As the Chancellor frequently reminds us, this has not been at the cost of unemployment or slower growth. The UK has lower unemployment than either the US, the eurozone or Japan, and growth, while lower than the US, has been at least as fast as the eurozone since 1997, and of course vastly better than Japan.
I don't think it would be fair to ascribe this better economic performance to monetary policy: the roots of that are in better structural policies over the past 20 years than either the eurozone or Japan and indeed to sensible fiscal policy too. But you can fairly say that monetary stability has not been achieved at cost to output or jobs; that is pretty clear.
Other measures of performance? We still have higher short-term rates than either the eurozone or the US and much higher than in Japan where rates are zero. But that is not necessarily a bad thing. In a sense we need these rates to contain the economy, which might grow too quickly were it not restrained.
If you look at long-term rates, as measured by 10-year bond yields, we have converged on the US and eurozone. Instead of being a bit higher we are now the same. If you are concerned about enabling companies to borrow for investment at a reasonable cost, long-term rates are more important than short-term ones: the latter are the price of working capital, the former are for long-term fund raising.
And sterling? One of the criticisms of British monetary policy has been that the interest rates needed to contain growth to manageable levels have been too high for our exporters. The result has been a two-speed economy, with services booming but manufacturing in trouble. It is perfectly true that there has been a dilemma here, but if one is concerned about exchange rate stability rather than the absolute level of the currency, the pound has, since mid-1997 actually been extremely stable. It has been more stable on the weighted measure since then than the dollar, which has climbed; than the euro, which has plunged; and than the yen, which has been all over the place.
Whether the level of the pound is too high in the longer term is open to debate. The majority view is that it is, but there is a growing minority view that the scope for increased productivity is such that something close to the present level should be sustainable. This latter view is supported by the fact that the UK is in trade surplus with the US and that there has been no deterioration of its trade deficit with the eurozone. Any worsening of the deficit has been in trade with the rest of the world, in particular emerging East Asia.
In any case the whole craft of monetary policy is to try to reconcile different objectives, and the service industry/manufacturing one is just the sort of imbalance that policy has to try to steer between.
If the Bank has managed it pretty well – arguably better than Fed, probably better than the European Central Bank and certainly better than the Bank of Japan – then its members, in particular Sir Edward, should take a bow. Indeed my main worry is that the Bank has so far done too well. That is just the time when things go wrong. So let's stop the congratulations there.Reuse content