It all used to be so simple for the Bank of England.
In those days long ago when inflation was low and steady and the economy seemed to purr along, Threadneedle Street gave the odd tweak to the cost of borrowing and that was that. The granting of independence to the Bank by Gordon Brown in 1997 was seen as a masterstroke – taking policy out of the hands of incompetent and meddling politicians and handing it to able technocrats.
That was then. For the past six years, ever since the financial crisis broke, the conduct of monetary policy has been anything but simple. It involves more than the occasional quarter-point change in the official cost of borrowing. There are those who say the activist approach adopted by the Bank has put its credibility and independence at risk.
All these issues came to a head last week when the new governor, Mark Carney, provided forward guidance about the future course of policy. The Bank wanted to signal that it would only raise interest rates or unwind its £375bn quantitative easing programme in exceptional circumstances.
Carney was parachuted into the Bank by George Osborne with the brief of making Threadneedle Street a more growth-friendly institution and he has wasted no time in getting on with the job. The chancellor has done his bit to pump up growth through his subsidies to the housing market, but he expects most of the heavy lifting to be done by the Bank. Hence last week's commitment to keep interest rates unchanged at 0.5% until unemployment comes down from 7.8% to 7% or less. Hence, also, the concerns about the Bank's independence and its credibility.
In truth, these concerns are not new. The Bank's independence was called into question when the previous governor, Lord King, gave such strong backing to Osborne's austerity programme. And the Old Lady's credibility has been on the line for at least half a decade, a period in which it first failed to deal with the bubbles in the financial and housing markets, was then slow to cut rates when the economy nosedived into recession, and has subsequently turned a blind eye to above-target inflation. Carney's arrival has merely put these concerns into sharper focus.
Criticism of the way the Bank is conducting monetary policy also needs to be put into context, because the ultra-loose approach adopted by the Bank is the flipside to the ultra-tight policy adopted by Osborne.
Work by the American academic Alan Taylor has estimated the cost of austerity to the British economy. The results show that GDP would be 3% higher without the combination of tax increases and spending cuts – sufficient to bring national output close to where it was before the recession began. Changes to tax and spending are even more potent when interest rates are at rock bottom (or, in the jargon of the profession, at the zero interest-rate bound).
Preferably, Osborne should lay off the austerity and so take some of the pressure off the Bank to provide all the stimulus through a monetary policy that needs to grow ever more unorthodox to have an impact. It means buying up a third of the gilts market and providing a signal that interest rates will stay at barely above zero for years to come. Nobody knows how this will all end.
The long-term prospects for the economy would certainly not be harmed, and would probably be improved, by a different mix of policy. That might, for example, involve higher capital spending on house-building and cuts in payroll taxes to encourage employers to take on young workers, offset by a slightly less stimulative monetary policy.
That is not on offer given the government's belief that the Bank should be active and the Treasury (largely) passive when it comes to growth.
For the Bank to continue to keep the pedal to the metal, a couple of changes have been required. It has necessitated tweaking the Bank's legal mandate to hit a 2% inflation target. And it has meant relying on a relationship between inflation and unemployment that those of us with long memories recall as the Phillips curve.
This, needless to say, is all a bit of gamble but considered worth it by Carney and Osborne. Why? Because the economy has so massively under-performed in recent years that most (if not all) analysts think there is quite a lot of spare capacity that could be used up before inflationary pressures start to appear. The main evidence for this is that when the unemployment rate hovered around 5% in the first half of the 2000s, growth in average earnings held steady at, on average, 4% a year. The unemployment rate is currently 7.8%, there has been a general attrition of skills during the recession and its aftermath, and the jobless total came down substantially without causing inflation to pick up.
This is the new version of the Phillips curve, the relationship between wage growth and unemployment plotted by the LSE economist Bill Phillips in the 1950s. Until Milton Friedman came along, policymakers used to believe that the Phillips curve provided a menu of options: they could choose to have a bit less inflation if they were prepared to tolerate a bit more unemployment. This line of thinking went out of fashion from the mid-1970s, but now it is back. The Bank clearly believes that it can push down joblessness without any risk to inflation.
Indeed, the 7% threshold set by the Bank for considering the need for tighter policy looks quite conservative. That may be because Carney got some push-back from other members of the monetary policy committee and so had to come up with a compromise. But there is no reason, given the weak bargaining position of employees, why there should be a need for the Bank to move until the jobless rate reaches 6.5% or lower. If there is inflationary pressure in the economy, it will probably show up elsewhere: in a rising trade deficit and in house prices. That, at least, is the evidence from the long boom of the 1990s and early 2000s.
There are those who say that none of this solves the long-term problems of the economy, and they are right. Those who say this is the wrong sort of growth have a point too. But Osborne won't give two hoots about that. There is now a policy regime in place that should guarantee the economy is growing at a fair lick in the runup to the election. If the coalition loses in 2015 it won't be because the economy is in recession, but because living standards are lower at the end of the parliament than they were at the start.
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