Why the chancellor should tighten the Bank of England’s policy remit

 
Andrew Sentance
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IN THE run-up to the Budget, there is renewed speculation about a change in the remit for the Bank of England Monetary Policy Committee (MPC). Last Thursday, David Cameron’s economic speech and a front page Financial Times story suggested that Mark Carney, the new Bank governor, could be given more scope to “rescue the economy” with looser monetary policy.

This would take monetary policy in the wrong direction. Giving the MPC more latitude to pursue laxer monetary policies and allow even higher inflation would be a retrograde step.

The MPC remit is set out in a letter from the chancellor alongside the Budget. There are two components: maintaining price stability, defined in terms of the 2 per cent inflation target; and supporting the government’s broader economic policy for growth and employment -- as long as this does not conflict with the primary price stability objective. So far so good. But the remit letter runs to three pages. And, as the saying goes, the devil’s in the detail.

Currently, there are two key weaknesses in this detailed guidance. The first is that the Bank is given far too much “wiggle room” in the way it responds to “shocks and disturbances” to the inflation rate. The MPC has used this to tolerate very significant and persistent deviations from the inflation target over the past five years. Twice since 2008, inflation has exceeded 5 per cent and in the past couple of years it has averaged over 3.5 per cent.

Despite this, the MPC has taken no action to restrain inflation. In fact, the actions it has taken – injecting more quantitative easing by printing money to buy government bonds –have more likely than not raised inflation,

The MPC pursued this policy to support growth – but tolerating high inflation has had the opposite result. It has squeezed consumer spending and held back the economy. So the first change I would propose to the MPC remit is that the Committee should be required to take policy action in support of its price stability remit – and should only be excused from this responsibility if there is a direct instruction from the chancellor to the contrary.

The second change relates to the requirement for the MPC to support the government’s economic policy objectives. Under the current mandate, the MPC is required to support “sustainable and balanced growth that is more evenly shared … between industries.” This focus on industrial rebalancing of has encouraged the MPC to pursue a competitive exchange rate, designed to encourage the growth of manufacturing industry and exports.

In his most recent speech, Sir Mervyn King used the words “rebalance” and “rebalancing” nine times, and he has repeatedly suggested that he would like to see the pound lower. Yet there is very little evidence that any industrial rebalancing is occurring under current policies. Manufacturing output remains well below its pre-recession level whereas output in the services sector has already recovered beyond its 2008 peak.

The MPC appears to believe that allowing the pound to fall far enough for long enough, we will get a better economic recovery supported by a stronger manufacturing sector. The evidence suggests the opposite. All we are getting from a weak pound is higher inflation and a bigger squeeze on consumer spending.

The foreign exchange markets, however, are taking their cue from official policy statements and the pound continues to slide. At the end of last week sterling was below both $1.50 and €1.15 for the first time in three years. And it has fallen to a historic low against the Chinese yuan.

The MPC remit should be stripped of language which encourages the Committee to support policies of this sort. The last successful devaluation of the pound was in 1949 when the value of sterling was readjusted to its role in the post-war economic order. The long decline in sterling’s value against other currencies from 1967 until 1976 only brought higher inflation, weaker economic growth and more volatility in its wake. And the same is happening this time round.

So the chancellor would be quite right to review the MPC remit in his Budget statement. But he should be tightening and not loosening his guidance. The MPC should be held much more clearly to account for their performance on hitting the inflation target and should not be encouraged to pursue a policy of aggressive devaluation – which amounts to Selling England by the Pound.

Andrew Sentance is senior economic at PwC and a former member of the Bank of England’s Monetary Policy Committee.