This article is taken from the February 2022 issue of The Critic. To get the full magazine why not subscribe? Right now we’re offering five issue for just £10.

This year sees the 25th anniversary of the Bank of England’s operational independence, made effective in May 1997 and granted formally in a 1998 Act. Almost certainly, 2022 will also see the most above-target inflation numbers since that change. The Bank will be heavily criticised and proposals will be made for reform. What has gone wrong? 

The crucial import of operational independence was that the Bank was given more or less exclusive responsibility to keep inflation on track. Its Monetary Policy Committee was meant to be free from Whitehall interference; its job was seen as technical, not political. With the inflation target the focus of attention, this job was to review the macroeconomic situation and to set interest rates. 

Here was a revolution in policy-making. The future would be different from the past, and the economic policy views held by the politicians of the day or top civil servants in the Treasury no longer counted. Of course, the Bank’s new powers came with extra accountability. If inflation were too high or too low, the blame fell on it. Neither the government nor Treasury mandarins were in the firing line. 

From December 2003 the inflation target — still determined by the Chancellor of the Exchequer — became a two per cent-a-year increase in the consumer price index. Deviations of up to one per cent either side of the middle two per cent number were not encouraged, but would not suffer a formal reprimand. 

But if inflation dropped beneath one per cent or exceeded three per cent  the Governor had to write an open letter to the Chancellor. The open letter might not be of abject apology, yet it had to commit to bringing inflation back to two per cent. 

The Bank kept inflation within the permitted band in all of 2004, 2005, 2006 and 2007. As its record between 1997 and 2003 had also been fine, the tenth anniversary of independence in May 2007  was accompanied by a virtual orgy of adulation from the commentariat. But the praise soon looked overdone. 

Critics deny that the quantity of money is relevant to the rise in inflation

Within a few weeks of the tenth anniversary, the global interbank market closed. Mistaken policy responses to banks’ problems were at least part of the cause of the ensuing Great Recession. Although output and employment were badly hit from late 2008, two phases of above-target inflation were recorded. Inflation hit 5.2 per cent in both September 2008 and September 2011. 

The first of these peaks could be interpreted as a lagged sequel to rather fast growth of the quantity of money in 2006 and 2007, and the second as due to some extent to the positive effect of the Bank’s asset purchases (or “quantitative easing”) on monetary growth. 

But QE had been needed to halt the Great Recession, while the inflation of 2010 and 2011 owed much to a global surge in commodity prices. For all the setbacks of the Great Recession and its aftermath, the average annual increase in consumer prices in the decade from 2009 was only slightly above 2.5 per cent, not too far from target. 

The current inflation is generally expected to be more troublesome, with a sharp debate emerging about its severity and duration. The mainstream position is that the rush of price increases reflects an assortment of temporary supply-side disruptions due to Covid-19. By extension, inflation will subside towards target as and when medical normality returns. 

According to the Bank’s November Monetary Policy Report, “we expect inflation to rise to about five per cent in the spring, but then to fall back”. An alternative argument is that the jump in inflation is attributable, above all, to excessive growth of the quantity of money (I discussed the inflation risks in the United States — where policy has been even looser and more inflationary than here — in my article “Reckless US faces a reckoning” in the June 2020 issue of The Critic). 

naysayers concede that although I have been right in my forecasts it is for the wrong reasons. Many of them deny that the quantity of money is relevant to anything. I am sticking to my guns. 

In the decade to February 2020 — before the Covid-related money explosion began — the compound annual growth rate of the M4x measure of broad money was 3.8 per cent a year. In an economy with a trend growth rate of real output of a bit more than 1 per cent, that was compatible with roughly on-target inflation. 

In the 20 months to October 2021, the Bank of England bought gilt-edged securities on such a large scale that M4x soared by almost 20 per cent. The implied annual growth rate is 11.4 per cent, more than seven per cent up on the earlier trend. I therefore expect inflation to lie between five and ten per cent for most of the next two years. 

Further, a sustained reduction in money growth to under five per cent a year is a condition — a necessary condition — of meeting the official two per cent inflation target in the current Parliament.