Bank of England (Economic Affairs Committee Report)

Lord Northbrook Excerpts

Thursday 2nd May 2024 Lords Chamber

[Lord Northbrook (Con)]

My Lords, I warmly welcome the report of my noble friend Lord Bridges’s Economic Affairs Committee. I will first look at the recommendations, and the Bank’s and the Government’s reactions to them. I will then consider the review by Dr Bernanke into the Bank’s forecast process, and finally give some thoughts of my own on recent years’ inflation and interest rate rises.

As the report states, the then Chancellor, Gordon Brown, set up this new operational independence after the 1997 general election. This had worked well up until 2021, and inflation and interest rates had been kept low.

The committee focused first on the interaction of monetary and fiscal policy. I agree with its recommendation that there should be

“clear lines of responsibility and effective communication between the Bank and HM Treasury”,

especially that HM Treasury should promote

“a fiscal stance which supports the inflation target it has set the Bank”,

particularly when interest rates are close to zero and the Bank has limited space to loosen monetary policy further. I especially support the committee’s view that quantitative easing had

“blurred the lines between monetary and fiscal policy”.

The report states that although QE was undertaken as a monetary policy decision, it had consequences for the management of public debt, so I endorse the report’s suggestion that the Bank and the Debt Management Office

“should draw up and publish a memorandum of understanding which clarifies how the interaction between monetary policy and debt management should operate”.

With regard to the Bank’s remit, I agree with the committee’s conclusion that it had been at risk of being asked to do too much. It should not, as the report says, need to expand it to government policy on climate change. I am completely supportive of the report’s view that giving the Bank’s Monetary Policy Committee and Financial Policy Committee multiple secondary objectives to consider risks drawing the Bank

“into the Government’s wider policy agenda”

and

“jeopardises the Bank’s ability to prioritise price and financial stability”,

which are the primary objectives of the MPC and FPC respectively.

I will move on to the topic of diversity of thought. It is interesting that the committee highlights evidence from witnesses who suggested that a lack of “intellectual diversity” at the Bank contributed to the misdiagnosis of inflation being transitory as it rose from 2021. I approve of the recommendation that

“it is imperative that its membership comprises people of different backgrounds and economic perspectives. The Bank must be pro-active in encouraging a diversity of views and a culture of challenge. This should be reflected in its hiring practices and its appointment procedures”.

I highlight the committee questioning that HM Treasury leads the process for appointing members of the MPC and that many of the appointees have a Treasury background, which

“does not strengthen the perception of independence”.

I approve of the recommendation that HM Treasury and the Bank’s Court of Directors commission an independent review of the appointments process to consider how public appointments are made, what best practice was for other central banks, and to propose measures which ensure that the appointments process is transparent.

Moving on to the subject of forecasting, the report also highlights the role of inadequate modelling techniques in misdiagnosing the rise in inflation. It suggested that this error, made by other central banks as well as the Bank of England, may have reflected a general reliance on dynamic stochastic general equilibrium models. Witnesses argued that, because these models assume that “inflation expectations” play a significant role in determining inflation and that central banks are assumed to be able to effectively influence those expectations through their actions, they tend to predict that inflation will return to its target role over the forecast period. However, although these underlying assumptions may hold in times of economic stability, witnesses suggested that they were unlikely to be valid during periods of significant economic change, leading central banks to underestimate the strength and persistence of inflationary episodes.

Turning to the subject of accountability, I do not agree with the report’s recommendation that the Bank’s actions should be regularly scrutinised by Parliament. The danger of this is that short-termism could re-emerge in its actions. However, I am content with the proposal that

“Parliament conducts an overarching review, supported by expert staff, of the Bank’s remit, operations and performance”

every five years.

The Bank of England’s response of February to the report is very disappointing. The governor, Andrew Bailey, seems to brush aside most criticism or advice, except emphasising that the Bank does focus on its primary objectives.

The Government’s response contained two interesting reactions. The Chancellor said that monetary policy and debt management

“remain distinct areas with separate mandates, responsibilities, and decision-making processes”.

He said that the framework for debt management

“has not changed as a result of developments in monetary policy”

over recent years, such as the introduction of QE. However, he noted that the Government and the Bank were “mindful” of the potential for quantitative tightening to interfere with the debt issuance programme conducted by the Debt Management Office. He noted that the Bank was liaising with the DMO to minimise this risk, in line with a commitment made to the governor in a public letter to the then Chancellor in 2020. Secondly, the Government seem to have taken on board the report’s recommendation that the Bank should not need to focus on subjects such as climate change.

I now move on to the review by Dr Bernanke of the Bank’s forecast process. The review found that the accuracy of the Bank’s economic forecast had

“deteriorated significantly in the past few years”

and noted that

“forecasting performance has worsened to a comparable degree in other central banks and among other UK forecasters”

over the same period.

The review made criticisms in three areas. First, it found that some of the Bank’s key forecasting software was

“out of date and lacks important functionality”.

Secondly, Bernanke suggested that the Bank relied on human judgment to

“paper over problems with the models”,

given the Bank’s bias towards

“making incremental changes in successive forecasts”.

He argued that such an approach was slowing

“recognition of important structural changes in the economy”.

Thirdly, he said that the Bank relied too much on its central economic forecast in communicating its outlook and policy decisions to the public. Fourthly, and most importantly, he recommended that the use of

“fan charts to convey the range of uncertainty”

in the central forecast should be dropped. We await the response of the governor to the review.

Finally, these are my thoughts on what is not in the report and is overlooked by the review. I am afraid that the MPC and the governor were asleep at the wheel. At the Society of Professional Economists dinner in September 2021, when inflation was at nearly double its target, the governor said in his speech that the rise was transitory. I note the special circumstances of Covid and the Ukraine war, but why did the MPC not consult the regional offices to see what was going on on the ground? I was doing a building project at the time and suddenly realised that the cost of bricks, plaster, glass and render was rising in an extraordinary way and they were difficult to get hold of. While I am not an economist, I feel that QE was kept on for too long. As many noble Lords have said, the governor should have paid more attention to the money supply increase that presaged the major inflationary climb in the late 1980s and raised interest rates earlier, which would have limited the rise in inflation.