Gordon Brown had a surprise in store for Eddie George when he summoned the then governor of the Bank of England to a meeting at 11 Downing Street on bank holiday Monday, 25 years ago this week.
For the past two years, Labour’s new chancellor had been working on a plan to give Threadneedle Street the right to set interest rates and now he was ready to tell George about it. Secrecy was complete. The first the City heard of the idea that henceforth it would be the Bank’s job to hit the government’s inflation target, was when it was announced 24 hours later.
Accompanying George was his private secretary Andrew Bailey, since elevated to the governor’s office himself. Bailey was there to see George’s surprise at Brown’s news – but now he has to steer the Bank through its trickiest time since independence. The annual inflation rate is 7% – its highest in three decades – and is set to move even further away from the official 2% target. The City expects the Bank to raise borrowing costs to 1% on Thursday – the fourth time in a row it has raised rates.
Speaking before the quiet period when the Bank avoids public pronouncements about the looming interest rate decision, Bailey said nobody at Threadneedle Street had seen Brown’s independence announcement coming.
“It had, of course, been mused on as a concept for some years – but the idea that the New Labour government would implement it, immediately surprised almost everyone, I think,” he said.
Bailey recalled Brown producing a letter outlining his plans. “Eddie, of course, was very supportive of the decision – and the famous letter now sits in the Bank of England’s museum. Though I confess it is not in mint condition, as for a number of weeks after Gordon handed it over, it went around in my briefcase.”
Under Brown’s proposal, the Bank had a legal obligation to hit the government’s inflation target. Those responsible for setting interest rates were to be quizzed by MPs; the governor would have to write a letter if inflation deviated more than a percentage point from its target. The chancellor would appoint four outside experts to the Bank’s monetary policy committee, who would set policy along with the governor and four other Threadneedle Street insiders.
For the new chancellor, the advantages of the new approach were two fold: the Labour government would get kudos from the financial markets for ceding control over interest rates; and the Treasury would have more time to concentrate on sorting out the UK’s long-standing economic problems.
Labour’s 1997 manifesto was kept deliberately vague about the plan, Brown said. “We didn’t want to go into the election saying we would make the Bank independent because the Tories would say interest rates would go up.”
The Bank’s reputation was at its zenith during the first decade of independence. Inflation barely deviated from its target and the economy grew steadily. The MPC needed to do little more than give the occasional modest tweak to interest rates, which peaked at 7.5% in 1998.
That was to change. By the time the financial crisis of 2007-09 was drawing to an end, the Bank had cut interest rates to 0.5% – then the lowest in its history – and begun the money creation process known as quantitative easing. A second Great Depression was avoided but economic performance remained lacklustre.
Bailey said: “Looking back, it’s clear that long-run structural changes had been pushing down on interest rates for many decades prior to the collapse of Lehman. Those became very apparent after the financial crisis.”
Bailey thinks these structural factors – such as demographic changes and weaker productivity growth – are likely to prove persistent.
Brown said Bank independence had stood up well as a concept but added: “It is going to be tested in a period of stagflation. We have got to get away from the idea that central banks are the only game in town.”
Howard Davies, a Bank deputy governor at the time of independence and now chair of NatWest bank, said the Bank had been too slow to raise rates as inflation has gone up, but added: “Are we better off than if we hadn’t done it? Yes. Overall it’s been pretty successful. When it happened, the European Central Bank was being created on a super-independent model and the Fed was independent. Saying interest rates were going to continue to be politically determined would have been a difficult position to sustain.
“I said last July that the Bank should be raising rates and if it didn’t, it would eventually have to do more. The Bank didn’t want to spoil the party and I can understand that, but a touch on the tiller would have been sensible. It is dangerous to be seen to be behind the game.”
In a speech last year, Mervyn King – governor from 2003 to 2013 – criticised central banks for their King Canute theory of the cost of living, under which inflation will stay low because they “say it will”. There had been a decade of sluggish economic growth despite the largest monetary stimulus the world had ever seen and it was “surely time to recognise that many if not most economic problems are not amenable to monetary policy solutions, King said.
Bailey rejected the idea that the Bank has let the inflation genie out of the bottle, yet added: “The inflation targeting framework is going through its greatest test so far. But we need that framework now more than ever.”
The governor said the UK economy has been buffeted by a series of “massive shocks”, which have pushed up energy prices and inflation.
“The MPC simply doesn’t have the tools to offset a supply side shock like this. That would mean raising interest rates to the point that spending was so weak that the prices of other, domestically produced, goods and services fell. That would be damaging and would go against our mandate to avoid causing excessive volatility in output. But don’t doubt for a moment our absolute commitment to getting inflation back to target.”