Economy · August 5, 2022

What is the Bank of England’s mandate on inflation and why it matters

The Bank of England has come under increasing criticism from conservative MPs who say the central bank has been too slow to deal with rising inflation.

Andrew Bailey, the bank’s governor, warned this week that consumer price inflation, which already hit a 40-year high of 9.4% in June, will exceed 13% by the end of the year.

Liz Truss, the foreign secretary and leader in the race to become the UK’s next prime minister, said in one of the leadership’s protests this week that she wants to change the central bank’s mandate to make sure it controls inflation. Here the FT examines how the BoE plays its role and where it stands relative to its peers.

What is the BoE’s mandate?

The Bank of England has the main mandate to maintain price stability. It also supports the government’s economic policy, including its growth and employment objectives.

The UK government of the day sets the inflation target for price stability, which is currently 2% based on the consumer price index. This goal is the same for most central banks in advanced economies, including the US Federal Reserve, the European Central Bank, and the Bank of Japan. Unlike the BoE, all three of its peers set their own inflation targets.

The Fed has a second target for maximum employment, which allows the US central bank to give more weight to labor market developments than the BoE can in setting monetary policy.

The BoE’s inflation target is generally confirmed by the government every year. The last time it was changed was in December 2003, when it replaced a 2.5% target based on the retail price index.

If inflation exceeds or exceeds the target by more than 1 percentage point, the BoE governor is required to write a letter to the clerk explaining why and what actions the bank is taking to resolve the situation.

Ruth Gregory, a senior UK economist at Capital Economics, said the BoE’s mandate was “at least on paper, the least tolerant” of rising inflation than the Fed, ECB and BoJ.

How does the mandate relate to the bank’s ability to set interest rates?

Since it gained operational independence from Labor Chancellor Gordon Brown in 1997, the BoE decides for itself what policy action it should take to achieve its inflation target.

The bank influences price growth in two main ways. First, it sets the “bank rate” – the interest rate that a central bank charges other national banks to borrow funds – and takes steps to ensure it is passed on to households and businesses.

Second, it can use asset purchases, also known as “quantitative easing”. When the bank buys bonds, the interest rate for bondholders falls, leading to lower rates on loans for households and businesses. This should help increase spending and keep inflation in line with the target.

James Smith, director of research at the Resolution Foundation, said this approach has been “a pillar of British economic policy over the past quarter century”, a period during which inflation averaged almost exactly 2%. .

Would changes to his mandate undermine the independence of the BoE?

Some experts argue that there is room for revision. “It makes sense, 25 years later, to review the issue [of the mandate] and look at the things they can improve, “said Costas Milas, a finance professor at the University of Liverpool.

In 2013, Conservative Chancellor George Osborne revised the BoE’s mandate to give formal support to the central bank’s practice of letting inflation exceed its target if the alternative threatened to trigger an economic downturn.

Changes to the mandate could include a different tolerance range for the target, the introduction of money supply targets, or changes to the voting system for external members of the Monetary Policy Committee.

However, some economists point out that in most other advanced economies, instead of trying to change the mandate, most central banks review their strategies to ensure they can fully comply with it.

And many have expressed concern that any government requests for a mandate review raise questions about the independence of the BoE.

To the extent that this has become a central part of the leadership debate, “there is a concern about the degree of politicization of this issue and the potential risk to the BoE’s perception of independence,” said Paul Hollingsworth, chief economist. European Union of BNP Paribas.

Krishna Guha, vice president of investment banking consultancy Evercore ISI, said that any talk about the mandate review risks injecting “uncertainty into the financial markets and the business community, this uncertainty has economic costs, so it shouldn’t be done lightly or without great care. “

Has the BoE fulfilled its mandate?

With annual CPI inflation averaging almost exactly 2% since the bank’s independence in 1997, it “suggests the BoE did a good job,” said Andrew Goodwin, an economist at Oxford Economics.

Inflation is now well above the inflation target, but it is also in most countries due to the surge in commodity prices following the Russian invasion of Ukraine.

With an inflation rate of 9.1 percent, the US has only slightly less price pressure than the UK. In many euro area economies, easing labor markets and government support for households facing rising energy prices have kept price growth lower.

Beyond the differences in rates, inflation is at its highest for many decades in most advanced economies.

Hollingsworth said reaching the 2% target given the double shock of the pandemic and the war in Ukraine would have been almost “impossible for monetary policy alone”.