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The role of the Bank of England has continued to evolve since its creation in 1694 to finance a war with France. Its main task today is to control prices, which it has largely succeeded in since it took control of interest rates 25 years ago. But like other central banks, it is now struggling to calibrate policy in response to economic shocks triggered by the pandemic and Russia’s invasion of Ukraine. UK inflation has far exceeded its official target, leaving an institution long seen as a model for others to follow in the face of a credibility crisis.

1. How is the system supposed to work?

After the collapse of the Bretton Woods fixed exchange rate regime in the early 1970s and the high inflation that followed, many central banks, including the BOE, adopted a principle enunciated by the Nobel Prize-winning economist Milton Friedman: that the best way to ensure stable economic growth and a robust financial system is to focus on maintaining price stability. They do this via what is called inflation targeting – explicitly aimed at keeping prices up by a small amount each year. The BOE says this makes it easier for businesses to set the right prices and for individuals to plan their spending.

2. Who sets the inflation target?

The BOE is responsible for achieving an inflation rate set by the government each year. Currently, that rate is 2% based on the consumer price index, a target it shares with most central banks in advanced economies. If inflation diverges by more than one percentage point in either direction, the bank’s governor must write to the Chancellor of the Exchequer – Britain’s finance minister – explaining why and what the bank will do about it.

3. How does it control inflation?

Its main policy tool is the discount rate, the interest rate it pays to commercial banks that deposit money with the BOE. For these banks, lending to consumers and businesses is only worthwhile if it pays better than lending risk-free to the BOE. So when the bank rate goes up, banks charge everyone more, which restricts the supply of money in the economy and dampens prices. In the same way, when the discount rate falls, the money supply tends to rise and prices to rise. Between 1997 and the eve of the pandemic, UK inflation averaged 2% a year.

4. How has the role of the BOE evolved?

Prior to 1997, interest rates were set by the Chancellor, with the Governor of the BOE providing advice. Within days of taking office, the Labor government of Tony Blair gave the bank operational independence and created a nine-member Monetary Policy Committee headed by the Governor, a move intended to insulate monetary policy from the risk of political opportunism. The BOE was initially assigned an inflation rate target of 2.5% based on the retail price index excluding mortgage interest payments. In 2003, the target was moved to 2% based on the CPI. In 2013, the remit of the BOE was again changed when George Osborne, the Conservative Chancellor, declared that letting inflation run above target was tolerable if necessary to support growth and jobs. At the time, inflation was approaching 3% and the economy was emerging from the eurozone sovereign debt crisis.

5. What happens now?

Inflation was 9.4% in June and is expected to peak at 13.3% in October, the highest since 1980. This is not at odds with the pressures experienced by other advanced economies, where prices are rising at their fastest pace in decades. However, BOE Governor Andrew Bailey came under attack from members of the ruling Conservative Party and the press. Their main accusation is that the bank missed the signs of a price explosion and then acted too slowly once they started to appear. This, the argument goes, increased the likelihood of a long recession and rising unemployment.

6. So what is their solution?

Foreign Secretary Liz Truss, the favorite to succeed Boris Johnson as prime minister, said the UK was facing an unprecedented economic situation and the “business as usual” strategy was not working. The BOE should remain independent, but now is the time to review its mandate, she said. In a newspaper article, Truss said the recent spike in commodity-driven inflation has been “exacerbated by monetary policy.” How she would overhaul the current system is unclear. She didn’t say she would scrap inflation targeting, but did mention the possibility of expanding the target to include a measure of money supply or nominal gross domestic product.

7. Does money supply targeting work?

In the early 1980s, Margaret Thatcher’s government set money supply targets to deal with double-digit inflation. The idea was to reach a certain level of money supply to keep prices stable in the long term, even if it meant higher inflation in the short term. However, the parameters measured were volatile and sometimes contradicted other signals on the state of the economy. This led to the downfall of monetary targets in official circles and an unfortunate shift to manipulating exchange rates as a means of anchoring inflation. Proponents of the money supply measure regained some authority after Tim Congdon, who advised Thatcher, predicted the latest peak in inflation very early on after seeing money supply growth rise by 15% at the start of the pandemic.

8. Is the independence of the BOE threatened?

Some analysts have expressed concern that talks of revising the BOE’s remit again raise questions about the central bank’s independence from political interference. Any loss of credibility for the BOE could hurt the economy by making monetary policy less predictable, leading investors to demand higher yields for holding UK government debt. The chancellor has the power to change the remit of the BOE overnight by sending a letter to the governor. In practice, the government would probably consult formally on the matter to signal its intentions.

• A Bank of England guide to interest rates and how they work.

• The Chancellor who introduced Britain’s first inflation target in 1992 said it would be a mistake to abandon the scheme.

• QuickTakes on post-Brexit London and changes to the US Federal Reserve framework.

• QuickTakes archives on central bank independence and the perils of measuring inflation.

• Bloomberg Opinion’s Marcus Ashworth discusses the BOE’s “doomsday” economic outlook, while Paul J. Davies examines the motivation behind the Brexiteer attacks on the BOE.

• A seasoned British monetarist who was an early prophet of the global inflationary shock speaks out against the economics profession.

• Liz Truss’ inflation-fighting options if she becomes Prime Minister.

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