Economic Affairs Committee report: ‘Making an independent Bank of England work better’

In the days following the 1997 general election, the incoming Labour government provided the Bank of England with operational independence to set monetary policy.^[1] Prior to this, final responsibility for setting interest rates lay with the chancellor of the exchequer, with the Bank of England providing an advisory function. However, the incoming chancellor, Gordon Brown, argued that the perception that monetary policy was set with short-term political considerations in mind (rather than the long-term needs of the economy) was damaging investor confidence. Under the new monetary policy framework, the government would set a target rate for inflation and the Bank would have responsibility for setting interest rates to meet that target.

The Bank of England Act 1998 formalised this framework. In March 2023, to mark the 25th anniversary of this legislation, the House of Lords Economic Affairs Committee launched an inquiry into how the arrangements were functioning.^[2] The committee’s findings were published in a November 2023 report: ‘Making an independent Bank of England work better’.

1. Committee findings and recommendations

The committee noted that inflation has been low for much of the period since the Bank gained operational independence. However, it acknowledged the difficulty in identifying the precise impact that independence played, amongst other factors, in contributing to that. For example, globalisation was commonly cited by witnesses to the inquiry as being a significant cause of low inflation over that period. However, on the whole, the committee judged that the “enhanced credibility of monetary policy brought about by independence” contributed to the creation of a low inflation environment.^[3] It said that operational independence had “bolstered economic confidence”, noting that “the absence of political interference is seen by many as a major component of stable inflation expectations”.^[4] On this basis, it was the “strong view” of the committee that operational independence be preserved.^[5]

However, the committee also suggested that the framework for operational independence was being tested, with public confidence in the Bank having fallen as inflation remained well above its target rate of 2% for 2022 and 2023. The committee noted that supply shocks brought about by the pandemic and the fallout from Russia’s invasion of Ukraine had contributed to this; however, it said that “the persistence of above-target inflation over this period also reflects errors in the conduct of monetary policy”. Therefore, the committee made recommendations across a series of areas designed to “restore confidence in the Bank” and, therefore, preserve its independence with respect to monetary policy. These recommendations are summarised in the following sections.

1.1 Interaction of monetary and fiscal policy

The committee said that there should be “clear lines of responsibility and effective communication between the Bank and HM Treasury” when conducting monetary and fiscal policy respectively.^[6] It also said that it was the government’s job to “ensure they are consistent with each other” and 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.^[7]

The committee noted that quantitative easing (QE)—the bulk purchase of government bonds with newly created money—had “blurred the lines between monetary and fiscal policy”.^[8] It said that although QE was undertaken as a monetary policy decision, it had consequences for the management of public debt. Therefore, it suggested that:

[…] the Bank and the Debt Management Office (which is an agency of HM Treasury) should draw up and publish a memorandum of understanding which clarifies how the interaction between monetary policy and debt management should operate.^[9]

The committee also reiterated its request that the government published the ‘deed of indemnity’ which commits the taxpayer to covering any losses that might result from the Bank’s QE programme. The committee previously made the request for the deed to be published in its 2021 report on QE.^[10]

1.2 The Bank’s remit

The committee said that the Bank’s remit had “expanded considerably in terms of statutory objectives, functions, regulatory principles and matters to which it should ‘have regard’ and ‘consider’, in order to support the government’s economic policy”.^[11] It said that this was concerning and that the Bank was at risk of being asked to do too much. As an example, it cited the expansion of the Bank’s remit to include “a particular focus on stipulations to support government policy on climate change”.^[12]

The committee said that giving the Bank’s monetary policy committee (MPC) and policy committee (FPC) 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” (the primary objectives of the MPC and FPC respectively).^[13] Therefore, the committee recommended that the Bank’s remit be “pruned by HM Treasury”, so that it can focus on its primary objectives.

1.3 Diversity of thought

The committee highlighted evidence from witnesses who suggested that a lack of “intellectual diversity” at the Bank contributed to a misdiagnosis of inflation being “transitory” as it rose in 2020 and 2021.^[14] Therefore, the committee said 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.^[15]

The committee also highlighted the role of inadequate forecasting and 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 over-reliance by central banks 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 rate over the forecast period. However, while these underlying assumptions may hold in times of economic stability, witnesses suggested that they were unlikely to hold during periods of significant economic change, leading central banks to underestimate the strength and persistence of inflationary episodes.

On 28 July 2023, while the committee was in the process of collecting evidence, the Bank’s Court of Directors announced that Dr Ben Bernanke, economist and former governor of the US Federal Reserve, would lead a review into the Bank’s forecast process.^[16] The committee welcomed this news in its report, suggesting that the review should “seek to explain the value of models that seldom predict anything other than a return to the two per cent target over their forecast horizon” and consider whether appointments (at both official and MPC level) were creating sufficient diversity of thought.^[17]

The committee noted 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”.^[18] It therefore recommended 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 the appointment process is transparent.

1.4 Accountability

The committee said the Bank’s independence, combined with its substantial and expanded remit, mean that “significant powers are delegated to, and exercised by, a small group of appointed officials who are not part of the elected government”.^[19] Therefore, it is “imperative that the Bank’s activities and its remit are effectively scrutinised by, and its officials are held accountable to, Parliament”. The committee recommended that arrangements for parliamentary scrutiny be enhanced to achieve this. For example, the committee suggested that the annual letters which set the remit for the Bank’s MPC and FPC should be published in draft form to allow scrutiny of them, with the final remit letters laid before both Houses of Parliament and accompanied by an oral statement in each House. Additionally, it recommended that Parliament conducts an “overarching review, supported by expert staff, of the Bank’s remit, operations and performance” every five years.

2. The Bank of England’s response to the committee

On 7 February 2024, the committee published a letter it had received from Andrew Bailey, governor of the Bank of England.^[20] While acknowledging that many of the recommendations were directed at the government and/or Parliament, Mr Bailey sought to “address those issues that fall within the Bank’s responsibilities”.^[21]

With respect to the quantitative easing and public debt management, Mr Bailey suggested that the lines of responsibility were clear and that “existing arrangements ensure that debt management policies are consistent with the framework for monetary policy”.^[22] Given that these arrangements are set out in public documents, Mr Bailey said “it is not clear that a memorandum of understanding would add further information not already in the public domain”.

On the Bank’s remit, Mr Bailey said that the increase in the Bank’s responsibilities “reflect[s] the lessons learnt during the global financial crisis”. He said that the Bank’s “financial policy committee plays a crucial role in identifying and monitoring systemic risks in the financial system as well as in acting to counter them”. This, he said, “allows the MPC to focus on its primary objective of maintaining price stability”. Additionally, Mr Bailey said that primary objectives for these committees were “very clear” and that “secondary objectives are only considered subject to achieving the primary objectives”.

On diversity of views and challenge, Mr Bailey said that the MPC “benefits from the diverse expertise of external as well as internal members, and from support and challenge from the Bank’s excellent staff”.^[23] He said that the Bank runs open recruitment processes for its staff and that it “actively strives to ensure that there is a range of candidates from a diverse set of backgrounds”.^[24]

3. Government response to the committee

On 13 February 2024, the committee published a letter it had received from Jeremy Hunt, the chancellor of the exchequer.^[25] In this letter, the chancellor said that the government remained “fully committed to monetary policy independence” and welcomed the committee’s support for it.^[26]

With respect to the interaction between fiscal and monetary policy, the chancellor said that the government agreed that fiscal policy should be aligned with monetary policy. He noted that the government’s fiscal stance is due to become less supportive over the coming years, something which would help the MPC reduce inflation back to its target rate.

On monetary policy and debt management, the chancellor said that these “remain distinct areas with separate mandates, responsibilities, and decision-making processes”.^[27] 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 did also note that the government and the Bank were “mindful” of the potential for quantitative tightening (QT)—the Bank’s sale of government bonds previously purchased as part of the QE programme—to interfere with the debt issuance programme conducted by the Debt Management Office (DMO). He noted that the Bank was liaising with the DMO to minimise this risk, in line with a commitment made by Mr Bailey in a public letter to the then chancellor, Rishi Sunak, on 18 June 2020.^[28] Therefore, on the basis that “both the Bank and DMO continue to operate in line with their objectives” and that “each institution’s mandate and responsibilities are clarified across several public documents”, the current chancellor said it was the view of HM Treasury that “a memorandum of understanding would not effectively enhance these existing arrangements further”.^[29]

With respect to the deed indemnifying the Bank’s QE programme, the chancellor reiterated the government’s position that it should not be published, saying that this decision was “in line with HM Treasury’s risk assessment given market sensitivities related to the document”. The chancellor suggested that the disclosure of “operationally sensitive information relating to QE” could have an adverse effect on the DMO’s operations.^[30]

On the Bank’s remit, the chancellor said that both the MPC and FPC have complex roles and that “it is right that their remits reflect this complexity”.^[31] Additionally, he said that the hierarchy of objectives was clear, with the secondary objectives framed as being ‘subject to’ achieving the primary objectives. However, the chancellor also said that the government “recognises the benefit of improving the clarity and focus of the remit letters” and has “therefore taken steps to simplify the most recent FPC remit”. The referred to remit was published on 22 November 2023 (five days before the committee published its report) and the government subsequently faced criticism for having reduced the number of references the remit made to climate change,^[32]

With respect to parliamentary scrutiny of the remit letters, the chancellor said that the letters were published online and laid before Parliament, typically as part of a fiscal event package. He said that “going forward the government will also send a copy to the chairs of the Lords Economic Affairs Committee and the Treasury Select Committee directly”.^[33] However, he also said that “there is an important degree of stability between the remit letters year to year” and the government believed that publishing draft letters “could create extended periods of uncertainty”.

On the diversity of appointments to the Bank of England, the chancellor said that “the government recognises that to be effective, public bodies need to have a broad mix of skills, experience and backgrounds” and that “the Treasury promotes vacancies to a more diverse group and have used recruitment consultants where they have been able to prove value for money and an ability to widen the diversity of applicants”.^[34] Additionally, he said that external members of the MPC and FPC had been “successful in bringing in a fresh perspective and challenging the Bank’s executive”. Therefore, the government had “no current plans to commission an independent review on public appointments”.

4. Recent developments

4.1 Climate change and the FPC remit

On 14 February 2024, Mr Bailey gave evidence to the committee as part of an annual scrutiny session.^[35] During this evidence he said that because the government had taken things out of the remit that related to climate change, the FPC no longer had “quite such a precise regard for government policies in that area” and that the Bank had subsequently “somewhat reduced” the resources it devoted to it.^[36] On 16 March 2024, a public letter signed by “over 50 leading economists and civil society voices” was sent to Mr Bailey, with the letter expressing disappointment that the Bank had reduced its resourcing of climate change work.^[37] The letter said that “supply side shocks, which have been the major drivers of UK headline inflation, will only increase as the impacts of climate change and biodiversity loss intensify” and that:

[…] the UK financial sector continues to underprice climate risks, and finance emissions and nature-destruction at a pace and scale that posits a risk to global financial and monetary stability, as well as global climate goals.^[38]

Therefore, on the basis that “environmental risks fall squarely within core central bank mandates for price and financial stability”, the letter argued that the government’s decision to reduce the number of references to climate change policy in the FPC’s secondary objectives “should thus not undermine the Bank’s work in this area”.

On 19 March 2024, as part of her Mais lecture, the shadow chancellor, Rachel Reeves, said that she disagreed with the decision to downgrade the emphasis put on climate change in the Bank’s remit and that “the next Labour government will reverse these changes, at the first opportunity”.^[39]

4.2 Forecasting review

On 12 April 2024, Dr Bernanke’s review into the Bank’s forecast process was published.^[40] The review found that the accuracy of the Bank’s economic forecasts had “deteriorated significantly” in the past few years. However, it also noted that “forecasting performance has worsened to a comparable degree in other central banks and among other UK forecasters” over the same period, as there were “a series of large shocks that were, by their nature, difficult to forecast”. Nevertheless, the review made criticisms of the Bank’s forecasting process, as well as making associated recommendations on how to address them, across three different areas:

• Forecasting infrastructure. The review found some of the Bank’s key forecasting software to be out of date and lacking important functionality, with insufficient resources having been devoted to “ensuring that the software and models underlying the forecast are adequately maintained”. As a result, Bank staff are prevented from performing some useful analytical tasks, such as producing alternative forecast scenarios and using information gleaned from forecast errors to improve model specifications. Amongst other recommendations, the review suggested that the Bank devote more staff time and resources to model maintenance and development, thoroughly revamp its main forecasting model (‘COMPASS’), and pay greater attention to supply-side developments and their role in determining inflation.
• Supporting decision-making. The review suggested that the Bank relied on human judgements to “paper over problems with the models” given the bias the Bank has towards making only “incremental changes in successive forecasts”. Such an approach, it argued, risked slowing the recognition of important structural changes in the economy. To improve the MPC’s policy discussion, the review recommended that the Bank’s central forecast should be regularly augmented by alternative scenarios, including those which allow for direct comparisons of the likely effects of alternative policy paths on the outlook.
• Communication. The review assessed that, when communicating its outlook and policy decisions to the public, the Bank relied on its central economic forecast to a greater extent than other central banks. However, the conditioning assumptions for that forecast—such as the future course of the fiscal policy, exchange rates, or the Bank’s main interest rate—are externally determined (for example, the expected path for interest rates is taken from financial markets) and therefore do not always accurately represent the views of the MPC. As such, “the central forecast may not fully reflect the committee’s outlook for the economy”. The review therefore recommended that: the MPC “deemphasise” the central forecast in its communications; ‘fan charts’, which the Bank uses to try to convey uncertainty about its central forecast, should be dropped; and the MPC should favour a more qualitative approach to describing economic conditions and assessing risk and uncertainty.

The Bank of England’s response to Dr Bernanke’s review was published at the same time as the review.^[41] The Bank welcomed the review and committed to taking action on all of its recommendations. It said the recommendations:

[…] determine a clear direction of travel for the Bank’s forecasting methods and the role of forecasts and broader analysis in monetary policy discussion, formulation and presentation, while allowing for a range of design options for specific changes.^[42]

The Bank said it would need to “consider the design and associated implementation options in depth” and would provide an update on changes it proposes to make by the end of the year.

5. Read more

• Delphine Strauss and Aiden Reiter, ‘Ben Bernanke says BoE must revamp main economic model’, Financial Times (£), 12 April 2024
• Grace Blakeley, ‘The Bank of England independence disaster’, Tribune, 20 February 2024
• Tony Yates, ‘The House of Lords’ thinking on inflation is muddled and meagre’, FT Alphaville, 11 December 2023
• Stephen Millard and Carolina Garriga, ‘Reassessing the independence of the Bank of England’, National Institute of Economic and Social Research, 11 September 2024
• Simon Youel, ‘25 years of Bank of England independence shows we need a new approach’, Positive Money, 6 May 2022
• Andy Haldane, ‘What has central bank independence ever done for us?’, Speech given at UCL Economists’ Society Economics Conference, 28 November 2020
• Anna Stansbury and Ed Balls, ‘Twenty years on: Is there still a case for Bank of England independence?’, VoxEU, 1 May 2017

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Cover image by acediscovery on Wikimedia Commons.