Given the irresponsible fiscal policy announcement of the UK government last Friday, and the rout of the pound that followed, the Bank of England had few good options on Monday. Clearly, there is a fundamental macroeconomic conflict between the Truss government's so-called growth program of large-scale spending and the Bank's need to reduce trend inflation. While there cannot be a currency crisis in the UK, which has a flexible exchange rate and issues public debt in its own currency, a collapsing currency is still a major problem for its inflation and financial stability. The Bank had to make a choice.
So the Bank's governor, Andrew Bailey, issued a statement that the central bank's Monetary Policy Committee (MPC) would make a "full assessment" at its next scheduled meeting in November and that "The MPC will not hesitate to change interest rates by as much as needed…." The pound then continued to fall, and market expectations priced in more future interest rate increases, up to 6 percent in 2023.
It is right and necessary for an independent central bank to wait silently (in public) for the elected government to move forward with its fiscal plans, whatever they are. When the Bank of England leadership made clear a preference on fiscal policy for one party's platform in the run-up to the 2010 UK election, it was a grievous mistake. But it is also right and necessary for an independent central bank to speak frankly about the economic impact of the sitting government's fiscal plans once made and state that it will alter policy in response. Part of the inflation problem in the US at present is because the Federal Reserve failed to respond publicly to the massive short-term fiscal stimulus of the American Rescue Plan once passed in March 2021. There is a point in the sequence where the central bank should not stay neutral or encouraging (just as elected officials are free to criticize monetary policy ex post).
I believe that the Bank of England should be making it clear that the government's reckless budgetary statement is having consequences that will surely require higher interest rates. The Bank can do so by making clear the program's implications for the UK economy and thus for what the Bank will do with interest rates. When a government's discretionary expansionary fiscal policy leads to a falling rather than a rising currency, despite rising rates, it is a clear signal that markets doubt the credibility of the government's economic competence or goals, in this case for good reason.
One option would have been for the Bank to remain silent, letting the currency fall further. This would have been a clear statement that depreciation of the pound was only to be expected, given the fiscal policy, and the onus was on the government to reverse that policy. That would be a risky choice, and if a newly installed Prime Minister and Chancellor had privately made clear they would not reverse until calamity hit, it would be irresponsible for the Bank to let the pound go into free fall.
Once the Bank decided to speak, however, it should have put more emphasis on a promise of higher interest rates, rather than sounding neutral about the proposed fiscal policy and even positive about parts of it. For example, I would not have acknowledged that the initial effect of the energy price caps would be to reduce headline inflation since that benefit is likely to be offset, perhaps fully, by the inflationary effects of tax cuts and depreciation of the pound. Certainly, I would not have included in the statement the seemingly complimentary comment, "I welcome the Government's commitment to sustainable economic growth," when the option was available to make no normative comment at all.
So, the statement I would have issued would read as follows:
"It is a simple economic reality that sustained large movements in exchange rates will affect the UK inflation forecast, and therefore the amount and duration of moves in the Bank's policy rate in response. It is also a simple reality that the Bank takes the Government's programs as given when making our forecasts, so large movements in HM Government's fiscal stance will be responded to by monetary policy in so far as they alter the inflation outlook on net.
Our path of interest rate hikes in the period ahead therefore will likely have to steepen and lengthen from what it was before the Chancellor's announcement last Friday and the subsequent movements in the trade-weighted pound exchange rate (if those changes persist). If in the Monetary Policy Committee's assessment the inflation outlook will be higher, policy will be set accordingly. While it remains for the Committee to make a more precise update of the economic outlook ahead of our November meeting, there is no question that outlook must be for significantly higher inflation now than it was when we last met.
The exchange rate is not a target of the Bank's monetary policy. The pound is not in a fixed exchange rate arrangement, and therefore there is no market-traded level of the pound that threatens the Bank's mandated goals in and of itself. The impact of movements in the exchange rate, however, can be material for the inflation outlook, and accelerating movements can be destabilizing in extreme situations for inflation expectations and financial markets.
As was the case in 2008-09, the MPC is ready to make rapid adjustments in the stance of monetary policy between scheduled meetings as part of our mandate should financial conditions warrant. These adjustments could be in the policy rate, in balance sheet operations, or both, as needed. If we see acute indications of rising financial stress or jumps in inflation expectations, we will not wait for a planned MPC meeting to respond."
The irony is that the founding triumph of the Bank of England's inflation targeting regime was the anchoring of inflation when the pound left the European Exchange Rate Mechanism in 1992, 30 years ago this month. For the three decades since then, including during the Global Financial Crisis, the Bank was able to largely ignore the exchange rate when setting monetary policy. This was because it was confident that the pass-through from moves in the sterling exchange rate to domestic inflation would be temporary and one-off.
As I warned starting in 2017, Brexit would undermine this anchor because it would make less credible the commitment of UK governments to stability. A smaller, more closed economy, with less access to markets and more friction with its largest economic partners, would be less buffered from economic shocks. Large inflation shocks would then be more persistent contributing to trend inflation, not simply one-off as before.
That meant the UK macro regime was going partway back to the 1970s, irrespective of the Bank of England's commitment to its inflation target. The MPC would have to again start to keep one eye on the exchange rate when setting policy, not solely focusing on the domestic outlook.
Now, the Truss-Kwarteng fiscal policy package has taken the UK policy regime right back to 1974, bringing pound weakness front and center. The years that followed were the nadir of British postwar economic performance and awful for the British people.
One key difference now is that the Bank of England is independent. That independence should be exercised to put up rates quickly all the while explaining to the public that interest rates will have to go even higher for longer than they otherwise would have, given the government's fiscal stance and its impact on the pound.
As with Brexit, UK elected officials have the right to disregard predictable and predicted economic costs. And as with Brexit, the Bank was right to stay publicly silent on those costs until the political decision was made. Now, however, the Bank of England should not hesitate to respond to those sad realities and to matter of factly attribute them to the government's choices.