Bank of England Risks Independence and Pound by Not Defending Inflation Target

 | May 12, 2017 | 9:00 AM EDT
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The Bank of England's monetary policy meeting was as uneventful as humanly possible at a time of Brexit and early general elections. As expected, the bank did nothing. It probably will do nothing for a long time. But this inactivity risks opening the central bank to criticism that it is sacrificing its main objective -- that of keeping inflation low. This, in turn, could make it lose its independence.

A lot of analysts expect the central bank not to raise interest rates at all, come what may, before the U.K.'s actual departure from the European Union, scheduled to take place no later than March 29, 2019, at midnight Brussels time.

But inflation already has exceeded the central bank's 2% target for two consecutive months, printing 2.3% in February and March. What's worse, the central bank itself predicts that inflation will keep rising and says it will do nothing about it. From the Bank of England's Thursday statement:

"The MPC expects inflation to rise further above the target in the coming months, peaking a little below 3% in the fourth quarter... Attempting to offset fully the effect of weaker sterling on inflation would be achievable only at the cost of higher unemployment and, in all likelihood, even weaker income growth. For this reason, the MPC's remit specifies that, in such exceptional circumstances, the Committee must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity."

In other words, as Governor Mark Carney has said repeatedly, the central bank is willing to "look through" inflation for a long, long time. The problem with that stance is that, unlike the Federal Reserve, the Bank of England doesn't have a dual mandate (although there is some debate about that; indeed, the idea for this column came after a friendly argument about this with my colleague James Skinner, who writes for The Street and The Deal).

The Bank of England's mandate is as follows: "The Bank's monetary policy objective is to deliver price stability -- low inflation -- and, subject to that, to support the Government's economic objectives including those for growth and employment. Price stability is defined by the Government's inflation target of 2%."

The Fed, on the other hand, says: "In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary."

This seems like a small difference, worthy of note only to central banking nerds like me. But it can make the difference between an independent Bank of England and one subordinated to the government.

Perhaps some investors remember Theresa May's speech to her Conservative Party gathering back in October last year. Here's a quick refresher on what she said: "While monetary policy with super low rates and quantitative easing have provided emergency medicine, we have to acknowledge some of the bad side effects. People with assets have got richer, while people without have not. A change has got to come, and we are going to deliver it because that's what a Conservative government can do."

At the time, there was speculation that this meant the Prime Minister wanted to fire Carney and take control of the central bank. A spokesperson for the Prime Minister said back in October that monetary policy is a matter for the Bank of England, which is independent.

But then, remember that Theresa May also said there would be no early elections. The Bank of England should take no solace from the Prime Minister's statements. The reality is, if the central bank fails in fulfilling its mandate, it will make it easier for the government to take away its independence. And its credibility will go first.

If you think an independent central bank doesn't matter that much, think again. Once Britain leaves the EU, the central bank will no longer be banned by the EU Treaty from buying government debt on the primary market -- in other words, as soon as the debt is issued. An independent central bank would be able to resist government calls to buy its debt and debase the currency. A subordinated one will not. That could spell the end of the pound's already diminishing status as a reserve currency.

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