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27 September 2022

The Bank of England is right to hold its nerve

It is not the job of central bankers to bail out a reckless government.

By Will Dunn

Here’s a conspiracy theory: the whole point of austerity was not, as David Cameron and his chancellor, George Osborne, claimed, to balance the public finances, but to destabilise them.

In the wake of the 2008 financial crisis the Conservatives saw the effect super-low interest rates had on asset prices – especially house prices – and thought, “our voters would love it if that continued”. So when they got into power they followed a destructive programme of fiscal policy, hacking tens of billions out of GDP through reduced public spending and forcing the Bank of England to hold interest rates at close to zero for years longer than it would otherwise have done to prevent a recession. Real incomes stagnated but the houses and cars that cheap debt buys (69.4 per cent of voters in Conservative seats are homeowners) made it look as if Britain was booming.

To reiterate, that’s a conspiracy theory, not the real explanation for austerity. But after Kwasi Kwarteng announced a commitment to £72.4bn of new borrowing in his mini-Budget on Friday – to which markets reacted with a historic sell-off of UK public debt and a collapse in the value of the pound that has taken it to within a few cents of parity with the dollar – a very similar narrative has taken hold.

Commentators and analysts close to the Chancellor and Liz Truss, such as Mark Littlewood, the director of the Institute of Economic Affairs (IEA, the free-market think tank with which the Prime Minister has a longstanding connection) and Kate Andrews, the IEA’s former associate director, have argued that the plunging value of the pound is all part of the plan. The government is deliberately spooking the markets, this argument holds, to force the Bank to raise interest rates. “If market reaction to this mini-Budget forces the Bank of England’s hand, that is a design feature, not a design flaw,” Andrews observed on Twitter. Patrick Minford, the economist who is a trustee of the IEA, said in July that interest rates of 7 per cent would be “a good thing”.

Some people might argue that devaluing the currency and triggering a historic rise in the price of public debt just to get the Bank on side is a bit like sawing one of your legs off in the hope of getting a date with a dishy paramedic: it might work, but it’s a bit drastic and not without consequences. And what happens if it doesn’t?

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This is a question the government is now asking itself with some urgency, because it hasn’t worked. The governor of the Bank of England, Andrew Bailey, released a statement yesterday afternoon (26 September) in which he said that the Bank did not plan to announce an emergency increase in rates. Instead, it will “make a full assessment at its next scheduled meeting [which isn’t until 3 November] of the impact on demand and inflation from the government’s announcements, and the fall in sterling, and act accordingly”.

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The pound, which had recovered slightly during the day on the widely-held assumption that the Bank would rush to help calm markets with an emergency intervention, slumped again as the statement was released. Doubtless this will confirm to Truss that the Bank is another pesky, unhelpful institution, like the Office for Budget Responsibility.

Of course, the government could try to soothe markets by unveiling the other half of its Budget and detailing the spending cuts it will make to balance public finances. But to do so would be to admit that a new era of austerity is the price of its own reckless policy. If it can get the Bank to raise rates first it can pretend that the violent belt-tightening is intended to cope with economic conditions imposed by someone else. This is why Kwarteng has set the date for announcing his fiscal plan (and the economic forecast his department has kept from the public) on 23 November.

And so we have a stand-off between the Bank and the Treasury – one that could, if it lasts several weeks, become very expensive indeed.

But there’s an argument for saying that the Bank has done the right thing here, and that monetary policy, the preserve of central banks, should not bail out fiscal policy, controlled by governments, when fiscal policy is senseless and destructive.

Take the example of the 2010s: conspiracy theories aside, it is reasonable to argue that, had the Bank raised interest rates meaningfully during austerity, the short-term pain would have been greater but house prices would not have become so dangerously inflated, people wouldn’t have splurged as much using car finance and credit cards, and the UK would not now be so critically exposed to rate rises. But for the Bank to have done so during austerity Mark Carney would have had to have felt comfortable turning off the tap of cheap debt and exposing that Britain wasn’t doing as well as it thought. This would have been very unpopular and might well have caused a recession.

Today, we are arguably paying the price for the Bank’s failure to exercise its independence in the past. A third of UK homeowners will come to the end of their fixed-rate mortgage payments within the next two years, and with rates now expected to hit 6 per cent, the mortgage payments on the average property could easily increase by several hundred pounds a month. Minford thinks this should be “part of the adjustment”.

Fortunately for the rest of us, Truss hasn’t made Minford the governor of the Bank of England (yet), and the Bank still has the opportunity to maintain its independence by raising rates at a time and volume it judges best serve its mandate to provide monetary and financial stability, rather than being pushed into drastic action by the government’s economic radicalism.

Unfortunately, this gives ministers the opportunity to blame the Bank for the mess they have caused. The only thing the Bank can do is to stand its ground.

[See also: Kwasi Kwarteng forgot that radicalism needs to be matched by credibility]