Mike Newton was Conservative parliamentary candidate for Wolverhampton West, and worked for the Bank of England during his career in the financial markets.
Andrew Griffith MP recently wrote a very thoughtful article for ConservativeHome outlining the rising risks in the gilt market. He is right to say that it is a matter of urgency we do something about the fact that our sovereign debt is now considered riskier by the market than any other country in the G7.
Thinking on from what Andrew said, should we be looking more radically at the future status of the Bank of England? Could a truly single mandate central bank both reduce the interest rates paid on government debt, and provide a path to sensible and equitable welfare reform?
Full disclosure: I am a former Bank of England staffer and have worked for over thirty years in the markets. I have seen first-hand what bond market crises look like, and how prevention is always better than cure.
The Bank of England currently has what I would call a ‘soft’ mandate to target inflation at 2 per cent, with wiggle room of 1 per cent either side. I call this a ‘soft’ mandate given that the Bank is also mindful of growth, employment, financial stability – and increasingly woke matters like climate change and gender equity.
In plain English, it would like to control inflation but not at the expense of other variables. This is a bit like me saying I would like to lose weight, but also continue to eat crisps, chocolate and fish and chips most days. It simply does not have credibility.
This word credibility is incredibly important and is at the heart of how government borrowing is priced.
If an investor is confident that their loan to a government through buying a bond will be repaid on time, and with minimal damage done to the real value of the loan over time because inflation is low and stable, then mathematics dictates that the interest rate demanded will be less.
This assumes that the supply of bonds, or issuance as it is known, will be constant, an important factor which I will return to later.
Despite the Bank’s best intentions, its credibility on inflation has been seriously damaged in recent years, and as a result the international markets require a higher rate of interest from the UK compared to peers. But this could easily be reversed with a series of reforms, most of which, if not all, could be accomplished by using existing legislation.
My proposal for discussion is this: the Bank should hard-target inflation at a 2 per cent ceiling and de-emphasise other parts of its mandate. This 2 per cent should be hit every quarter on an average basis, without exception. As a monetary hawk I am sympathetic to a monthly target, but it might be too rigid operationally.
As an owner of three small businesses – those being consultancy, railway loco leasing and hospitality – my reflex is to wince at what I have written. Would the real economy impact of true inflation targeting be too much for businesses, large or small, to bear? Is the risk to growth worth it?
Let us be clear: low and stable inflation would be the highest objective of monetary policy, with growth placed a distant second. This might scare some. But beyond the initial adjustment period, as the economy transitioned to inflation credibility, the impact would be highly positive.
Firstly, the burden of government interest payments would collapse, and the cost of new issuance would decline with it. This would allow tax cuts and facilitate an aggressive demand-side response, as people and businesses had more money to spend.
Secondly, businesses and households could plan easily for the future, knowing that inflation was going to be 2 per cent or below. Sure, there might be some uncomfortable volatility in growth, but the benefits from certainty around price stability would be enormous.
Sceptics might point to the impact of ‘temporary’ shocks on inflation such as COVID or energy? Isn’t it reasonable to look through these?
Experience has shown that this is the easy way out and creates further problems down the line. Once prices rise, it is very difficult to ratchet back inflation expectations. There is always a good excuse why the target was missed.
Temporary shocks become permanent. And central banks are often too confident in their ability to manage inflationary shocks and end up making mistakes that lead to permanently higher inflation by accident.
I want to conclude by discussing the other highly beneficial outcome from the proposed framework, and that is control of the welfare bill. This would lead to lower gilt issuance and get government borrowing down ever further.
I was at a Congleton Conservative Association dinner recently, and there was a discussion around the table on the Triple Lock, with views both for and against its retention – my view is that it needs modification. But the real question is if the Triple Lock was replaced, what should pensions be linked to that is fair, affordable and politically saleable?
This is where the beauty of hard targeting inflation really kicks in. If there is confidence that the inflation target will be hit, then linking pensions to the target meets all three criteria. It is fair, can be afforded, and is an easy political sale as it protects our senior citizens’ money.
I would also argue that linking all increases in benefits, and perhaps also public sector pay where there are no productivity improvements, to the inflation target, is a very fair way to stabilise and reduce an unaffordable welfare bill, and in the case of pay, ensure that taxpayers get good value for money.
I am very much anti-inflation as it is the ultimate regressive vice, reducing the incomes of the poorest and lowest earners most disproportionately. But it cannot be truly controlled until we take hard decisions about how this should be done.
The example of the Bundesbank during the Wirtschaftswunder is a historical example of how this no-nonsense approach has worked well in practice, although the (exaggerated) short-term risks to growth, particularly during shocks, are often too much for skittish politicians to stomach during normal times.
But as gilts yields head above 5 per cent, with welfare out of control and 30 per cent of young adults economically inactive, the time for easy choices is over.
The voters I have encountered recently on the doorsteps of the Midlands know this, and Kemi Badenoch is fast becoming a revered figure for her willingness to address the problems have others have given up on.
The Chindit memorial outside the MoD notes, ‘The Boldest Measures Are The Safest’. Generational change to the inflation target and the Bank’s mandate may be both the best option for the economy, and a political winner.
It deserves serious discussion.
Mike Newton was Conservative parliamentary candidate for Wolverhampton West, and worked for the Bank of England during his career in the financial markets.
Andrew Griffith MP recently wrote a very thoughtful article for ConservativeHome outlining the rising risks in the gilt market. He is right to say that it is a matter of urgency we do something about the fact that our sovereign debt is now considered riskier by the market than any other country in the G7.
Thinking on from what Andrew said, should we be looking more radically at the future status of the Bank of England? Could a truly single mandate central bank both reduce the interest rates paid on government debt, and provide a path to sensible and equitable welfare reform?
Full disclosure: I am a former Bank of England staffer and have worked for over thirty years in the markets. I have seen first-hand what bond market crises look like, and how prevention is always better than cure.
The Bank of England currently has what I would call a ‘soft’ mandate to target inflation at 2 per cent, with wiggle room of 1 per cent either side. I call this a ‘soft’ mandate given that the Bank is also mindful of growth, employment, financial stability – and increasingly woke matters like climate change and gender equity.
In plain English, it would like to control inflation but not at the expense of other variables. This is a bit like me saying I would like to lose weight, but also continue to eat crisps, chocolate and fish and chips most days. It simply does not have credibility.
This word credibility is incredibly important and is at the heart of how government borrowing is priced.
If an investor is confident that their loan to a government through buying a bond will be repaid on time, and with minimal damage done to the real value of the loan over time because inflation is low and stable, then mathematics dictates that the interest rate demanded will be less.
This assumes that the supply of bonds, or issuance as it is known, will be constant, an important factor which I will return to later.
Despite the Bank’s best intentions, its credibility on inflation has been seriously damaged in recent years, and as a result the international markets require a higher rate of interest from the UK compared to peers. But this could easily be reversed with a series of reforms, most of which, if not all, could be accomplished by using existing legislation.
My proposal for discussion is this: the Bank should hard-target inflation at a 2 per cent ceiling and de-emphasise other parts of its mandate. This 2 per cent should be hit every quarter on an average basis, without exception. As a monetary hawk I am sympathetic to a monthly target, but it might be too rigid operationally.
As an owner of three small businesses – those being consultancy, railway loco leasing and hospitality – my reflex is to wince at what I have written. Would the real economy impact of true inflation targeting be too much for businesses, large or small, to bear? Is the risk to growth worth it?
Let us be clear: low and stable inflation would be the highest objective of monetary policy, with growth placed a distant second. This might scare some. But beyond the initial adjustment period, as the economy transitioned to inflation credibility, the impact would be highly positive.
Firstly, the burden of government interest payments would collapse, and the cost of new issuance would decline with it. This would allow tax cuts and facilitate an aggressive demand-side response, as people and businesses had more money to spend.
Secondly, businesses and households could plan easily for the future, knowing that inflation was going to be 2 per cent or below. Sure, there might be some uncomfortable volatility in growth, but the benefits from certainty around price stability would be enormous.
Sceptics might point to the impact of ‘temporary’ shocks on inflation such as COVID or energy? Isn’t it reasonable to look through these?
Experience has shown that this is the easy way out and creates further problems down the line. Once prices rise, it is very difficult to ratchet back inflation expectations. There is always a good excuse why the target was missed.
Temporary shocks become permanent. And central banks are often too confident in their ability to manage inflationary shocks and end up making mistakes that lead to permanently higher inflation by accident.
I want to conclude by discussing the other highly beneficial outcome from the proposed framework, and that is control of the welfare bill. This would lead to lower gilt issuance and get government borrowing down ever further.
I was at a Congleton Conservative Association dinner recently, and there was a discussion around the table on the Triple Lock, with views both for and against its retention – my view is that it needs modification. But the real question is if the Triple Lock was replaced, what should pensions be linked to that is fair, affordable and politically saleable?
This is where the beauty of hard targeting inflation really kicks in. If there is confidence that the inflation target will be hit, then linking pensions to the target meets all three criteria. It is fair, can be afforded, and is an easy political sale as it protects our senior citizens’ money.
I would also argue that linking all increases in benefits, and perhaps also public sector pay where there are no productivity improvements, to the inflation target, is a very fair way to stabilise and reduce an unaffordable welfare bill, and in the case of pay, ensure that taxpayers get good value for money.
I am very much anti-inflation as it is the ultimate regressive vice, reducing the incomes of the poorest and lowest earners most disproportionately. But it cannot be truly controlled until we take hard decisions about how this should be done.
The example of the Bundesbank during the Wirtschaftswunder is a historical example of how this no-nonsense approach has worked well in practice, although the (exaggerated) short-term risks to growth, particularly during shocks, are often too much for skittish politicians to stomach during normal times.
But as gilts yields head above 5 per cent, with welfare out of control and 30 per cent of young adults economically inactive, the time for easy choices is over.
The voters I have encountered recently on the doorsteps of the Midlands know this, and Kemi Badenoch is fast becoming a revered figure for her willingness to address the problems have others have given up on.
The Chindit memorial outside the MoD notes, ‘The Boldest Measures Are The Safest’. Generational change to the inflation target and the Bank’s mandate may be both the best option for the economy, and a political winner.
It deserves serious discussion.