Labour can boost the credibility of the Bank of England and reduce the government’s borrowing costs by handing the central bank the power to set its own inflation target, a former rate-setter has said.
Sushil Wadhwani, who sat on the former chancellor Jeremy Hunt’s economic advisory council and was an external member of the Bank’s monetary policy committee (MPC), has urged the new government to use its large majority to push through the change and “signal that [it is] serious about entrenching price stability”.
The Treasury currently sets the Bank’s inflation target, which has stood at 2 per cent a year on the consumer price inflation index since the MPC was formed in 1997. While the target is in line with most other major central banks, governments in the US and the eurozone allow their monetary policymakers to set their own definition and target for price stability.
This discrepancy may be one of the reasons that investors have baked in a higher “inflation risk premium” into UK debt, Wadhwani wrote in a paper for the Centre for Economic Policy Research.
“It is plausible that markets believe that it is easier for politicians to amend the level of the inflation target than for independent technocrats to significantly amend their interpretation of price stability,” he said.
Wadhwani cited Liz Truss’s brief premiership, when she promised to change the Bank’s mandate with hints that the government wanted to replace the 2 per cent inflation target with one that aimed to target nominal GDP, or the cash size of the economy.
Labour should “actively consider” handing the Bank the power to set its own mandate as this could reduce the inflation premium and the government’s borrowing costs, Wadhwani said.
“A UK government that was willing to hand over the setting of the inflation target to the BoE may well be rewarded by a lower debt interest bill,” he wrote, pointing to a broader loss in credibility suffered by the institution in recent years.
The change to inflation-setting powers would be the biggest shake-up since Gordon Brown gave the Bank independence from the Treasury after Labour’s last landslide electoral victory in 1997. Under the terms of the independence arrangement, the government retained its power to set the inflation target.
In the US, the Federal Reserve has a dual mandate to ensure prices are low and stable at 2 per cent and to also “promote maximum employment”. In the eurozone, the European Central Bank targets average annual inflation across the single currency at around 2 per cent in the “medium term” and has a secondary treaty obligation to promote the policies of the European Union.
Rachel Reeves, the new chancellor, has been urged to reduce losses accumulated by the Bank through its bond-buying scheme, which could total £85 billion over the next decade.
To boost the government’s fiscal headroom, economists have pointed to a series of possible changes, including modifying the indemnity agreement between the Bank and the Treasury, making the Bank pay reduced interest to retail banks and a change in the measurement of the national debt.
Wadhwani said another route to minimising losses would be for the government to issue more inflation-linked gilts as a way to reduce demand for the assets and lower the UK’s inflation premium.
A 1 percentage-point drop in gilt yields would result in an approximate £21 billion saving for the government over five years, according to figures from the Office for Budget Responsibility.
