Why the Bank held off spending

Bank of England Image copyright Getty Images
Image caption When fiscal and monetary policy start to merge, who is in charge? The Bank or the chancellor?

When the Bank of England decided last week not to create more money to support the recovery, some of us wondered why they didn't offer an explanation.

Now we know they had at least two reasons to hold back, which they couldn't have put in the press release: the coming spike in inflation for October, and the Treasury's decision to relieve the Bank of the billions it has made so far from creating money to buy government bonds.

The sharp rise in inflation to 2.7% is more than most in the City expected, partly because the large rise in university tuition fees has made a much bigger difference than people thought. That factor alone raised the Consumer Price Index for October by just under one third of a percentage point.

Only a small proportion of the population is affected by these tuition fees, and even they don't actually have to pay them up front. So that part of the bump up in inflation might not affect consumer confidence and growth as much as other price rises.


But everyone is affected by the increases in food and energy prices that are coming down the track, many of which have still to feed into measured inflation.

So, at best, members of the MPC last week knew they were looking at a bumpy few months for inflation. Some even think it could go back to 3% by the end of 2013, before heading back down again - meaning another exchange of letters between the governor and George Osborne.

Inflation would then have been above 2% for more than 36 consecutive months and most of the past six years.

Of course, it's the longer term picture for inflation that ought to guide policy - not the prospects for the next few months. Tomorrow we'll find out the Bank's new forecasts for growth and inflation, which the members of the MPC also had to guide their decision last week.

It's possible that these will show inflation remaining higher than previously expected, for longer, partly as a result of the stickiness in energy and food inflation that we are starting to see now.

Or the Bank might think the prospects for the recovery next year are slightly weaker than in August, meaning that inflation is still in danger of falling below target in a year or two.

But there too, the members of the MPC had a piece of insider information last week that we did not have at the time: They knew that the Treasury was about to do some quantitative easing of its own.

Crafty or sensible?

By and large, most economists I speak to think the Chancellor's decision to take hold of that big cash surplus sitting in the Bank of England's quantitative easing account is perfectly sensible.

It's an issue that has been debated by academics for a while, though many wish Mr Osborne or his predecessor had sorted it out a long time ago, when the move didn't look quite so convenient.

It was always a bit silly for the Treasury to acquire more debt, solely in order to pay interest to another part of government (the Bank).

The move also brings the UK into line with the way that quantitative easing is handled elsewhere. The US Treasury pays the Federal Reserve interest on the US Treasury bonds that the central bank has bought on the open market as part of its quantitative easing, but the Fed always sends that money right back again.

Crafty, or sensible, we can say for sure that the change in policy represents a small easing in monetary policy, which will act much like another dose of quantitative easing over the coming months.

In the 1980s they would have called this "under-funding": There will be spending of £35bn this year which the Treasury was expecting to have to raise in the financial markets, which instead it will be getting free from the Bank, as three-years-worth of accumulated interest payments are transferred back to the Treasury.

Depending on how long quantitative easing continues, and what the Bank decides to do about its government bonds when they come up for redemption, there will be another £11bn or £12bn a year in free money for the Treasury after that.

The transfers will continue until the Bank has raised its own cost of borrowing above the level of interest it is receiving on its gilts, or starts to make losses selling them back to the market, probably for less than they bought them for.

Then the money would start to flow the other way. But in the meantime the Treasury would still have benefited from not having to pay all that interest.

That is why I would expect the Office for Budget Responsibility to tell us in the Autumn Statement that the Bank's policy of quantitative easing is going to save the government money overall, even if the Treasury does have to send some money back to the Bank.

Presumably they've checked with the lawyers to make sure that this does not violate the Maastricht Treaty, which forbids governments from using the central bank to finance any of their deficits.

Small beer

Not for the first time, we're reminded that these extraordinary times have made the dividing line between Bank's "independent monetary policy" and the government's budget plans rather murky.

Sir Mervyn King said the other day it would be wrong for the Bank to write off the government debt it had bought as part of its quantitative easing policy, because that would be an act of fiscal policy - and an irresponsible one, at that.

But if that's true, you might ask whether Sir Mervyn or his successor would really be in a position to stop a chancellor who decided to engage in a stimulus programme, funded by QE, any more than he could stop George Osborne loosening UK monetary policy slightly last week.

Bank officials will say it's all a matter of appearance - and degree. In the grand scheme of things, a £35bn loosening of monetary conditions over several months is pretty small beer.

Still, when monetary and fiscal policy start to merge, the lesson of last week is that the chancellor is still in charge.