Everyone in business knows you have to read the small print in the contract
to make sure you know where you stand when things go awry.
The recent surge in inflation and dramatic downturn in growth have forced
economists to do the same with the 1997 deal to give independence to the Bank of
When the government gave the Bank control of monetary policy, it gave it one
tool interest rates. It also gave it two targets not just the one that grabs
While everyone knows the Bank must meet an inflation target, the government
also insisted it support its economic policy, including its “objectives for
growth and employment”.
The problem for the Bank’s monetary policy committee is how to balance rising
inflation with a significant slowdown in economic growth. One calls for rate
hikes and the other for rate cuts.
Up until the middle of June, the Governor of the Bank of England, Mervyn
King, was clear where he saw his duty. Launching the Bank’s May quarterly
inflation report, he said the UK was “travelling along a bumpy road as the
economy rebalances”, adding: “Monetary policy cannot, and should not try to,
prevent that adjustment.”
The financial markets, which until then had priced in as many as five rate
cuts, flipped around and priced in a rise in rates from 5.0% to as high as 6%.
Alarm bells rang in the Treasury. “The Treasury’s irritation with the
hard-line stance of the Bank of England has been self-evident,” says Graham
Turner of independent analysts GFC Economics.
After inflation jumped to 3.3% in May, triggering an exchange of open letters
between the Governor and the Chancellor, Alistair Darling pointed to the small
print, saying: “The government will continue to support the MPC in the forward
looking decisions it takes consistent with the objectives… to maintain price
stability and support the government’s economic policy including its objectives
for growth and employment.”
Economists such as Joseph Stiglitz, the Nobel Laureate, have gone further.
“To focus this much attention on inflation is wrong,” he says. “The recipe of
raising interest rates, pulling the economy down and increasing unemployment
compounds the impact of inflation on the poor.”
In his letter to the Chancellor, King appeared to mollify his
anti-inflationary stance. The MPC realised an attempt to bring inflation back to
its 2% target within 12 months would lead to “unnecessary volatility in output
and employment”. In English: a recession and surging redundancies.
The result of the first round of this battle was a compromise on a happy
medium interest rates will stay on hold at 5% over the summer.
But with the Bank warning that inflation could hit 4% this year, King started
to worry that the MPC risked losing the credibility as an inflation-fighter that
it earned in the first decade of its existence.
Many economists agreed. “Where should we suppose inflation expectations will
then stand, if this [4%] forecast proves correct? And what will that do to UK
economic stability?” asks Stephen Lewis, chief economist at Monument Securities,
who worked in the City during the inflation spikes of the 70s and 80s.
Robert Lind, an economist at ABN Amro, says with surveys showing households
expecting inflation to hit 4.3% over the coming year, the Bank faces a “serious”
“The Bank should raise interest rates to re-establish its credibility, though
I doubt its willingness to do this,” he says.
Certainly, some MPC members mulled hiking rates in June. If firms pass on
rising fuel and food prices to consumers, who respond by demanding higher wages,
then other MPC members could switch sides.
That would go down badly in Whitehall. “The Treasury is hoping that interest
rates can be cut,” says Lewis.
“It would not understand a move aimed at bringing down inflation to prepare
for stabilising the economy and stimulating growth. That chain of cause and
effect is not part of Treasury thinking.”
A few days after the exchange of letters, King used his annual Mansion House
speech to the City to harden his stance on inflation.
“‘Target growth, not inflation’ is the cry. I could not disagree more,” he
said. “There should be no doubt that the MPC is prepared to take whatever action
is needed to return inflation to the 2% target.”
This tussle is part of a wider power struggle between the Bank and the
Treasury. King has fought off plans for a powerful financial stability committee
sitting outside the Bank and ensured that one, if not both, of his deputy
governors is appointed from within the Bank rather than filled by Treasury
Given that there are fewer than two years until a likely general election,
the battle over interest rates could become heated. Fortunately for the
Treasury, the Bank of England Act 1998 contains some more small print.
“If, in extreme economic circumstances, the national interest demands it, the
government will have the power to give instructions to the Bank on interest
rates for a limited period.”
The surge in retail sales in May has put an August rate hike on the agenda.
That may be too soon for the Treasury to invoke the emergency clause but the
small print is always there.