Is the Bank of England using the wrong tools?

November 4, 2021

Central banks like to maintain that interest rates are the main way they can influence the economy. But behind this there are more powerful tools to control the creation of credit. We look at how these tools have been used through history, and explore whether they could help with the current inflation pressures.

If you read headlines about rising inflation, you’ll see much of the current debate focuses on whether the central bank should respond to it by raising interest rates. As we’ve explained, raising interest rates probably won’t do much to curb inflation, but could instead damage the recovery.

These days, when the Bank of England adjusts interest rates, it changes what is called the ‘bank rate’, which is the interest it pays on the reserves commercial banks hold with the central bank. A change to this base rate influences the amount of reserves commercial banks keep at the Bank of England. This typically leads to changes in the rate at which banks lend their excess reserves to each other, known as LIBOR or SONIA, which are the benchmarks for which loans across the financial system are priced, and will thus influence other interest rates across the economy. The simple idea is that raising interest rates will discourage bank credit creation, and encourage people to save money rather than spend it, both of which are believed would curb the issue of “too much money chasing too few goods” and thus bring inflation down.

Changes to this base rate can be a blunt and ineffective tool. Simply raising the base rate increases the cost of borrowing across the whole economy, which is not much help when inflation is being driven by supply bottlenecks in specific sectors. Doing so could lead to huge ‘collateral damage’ by increasing costs on households, lowering demand (fuelling unemployment) and even sparking financial crises. Furthermore, to be most effective, such monetary policy relies on the banking sector passing interest rates on. Banks may be happy to pass on higher rates to borrowers, but they have a much poorer record passing them on to savers.

This raises the question of whether a more targeted approach could be more suitable to address current inflationary pressures, rather than the blunt hammer of changing the general price of money. Though we rarely hear otherwise, price-based monetary policies like interest rates are just one tool that central banks have employed throughout their history, and may not even be the most important ones for us to be focusing on.

Taking control of credit

Behind almost every ‘economic miracle’ from the past century, from Germany’s recovery from economic ruin in the 1920s, to the recent rise of China as a global superpower, are states exercising control over private banks’ ability to create credit, with policy tools often referred to as ‘credit guidance’ or ‘window guidance’. The latter term derives its name from the central bank’s discount window, where commercial banks access funds.

A whole range of policies could come under the umbrella of ‘credit guidance’, but among the most notable types are ‘credit ceilings’, which are quantitative restrictions on the amount of credit banks provide to the private sector, as well as more targeted lending quotas towards specific sectors of the economy. One of the most cited examples of such policies is Japanese window guidance, where the Bank of Japan set limits on the amount banks could lend, with lending prioritised for industrial purposes, based on a detailed ranking of business types. In Princes of the Yen, Richard Werner argues that window guidance was the main policy tool behind the Japanese ‘economic miracle’ after the Second World War, and that “it was so powerful that it rendered other policy tools mere support mechanisms.”

Credit policy in the UK

Throughout what is considered in the West as the economic ‘golden age’ of the 1950s and 1960s, central banks frequently used such credit guidance to channel investment towards strategic priorities.

In the case of the UK, from the 1950s to the 1970s the Bank of England had a number of credit policy tools, including hire-purchase controls, special deposit schemes and credit ceilings. For instance, in November 1967 the Bank of England issued a notice announcing “severe but very selective restrictions” on bank lending to the private sector and overseas borrowers. However, concerned with the UK’s balance of payments, the Bank decreed that “priority should be given to finance for production and investment necessary to sustain or increase exports”, imposing less restriction on finance for exports and shipbuilding, with short-term export finance “free of all restriction”.

Such credit controls lasted until the 1970s, when the Bank of England removed most of them, fearing – as Rishi Sunak does now – for the ‘competitiveness’ of the British banking system. The removal of credit controls, combined with the 1973 oil shock pushing up prices, saw credit creation expand phenomenally from this period.

Could such policies be adapted to keep a lid on the inflation we’re beginning to see today? For example, could the Bank of England place restrictions on the creation and flow of credit towards activities which don’t increase the productive capacity of the economy or to help us break our reliance on expensive fossil fuels? Though such policies could help target the current sources of inflation, such as energy shortages and high commodity prices, an obvious criticism may be that this could still have the effect of tightening credit conditions for the wider economy, meaning similar (though perhaps less widespread) negative side-effects to base rate rises. Moreover, research published by the Bank of England argues that their credit controls had little effect on inflation during the postwar era.

Credit guidance and inflation in Germany

For a more extreme example and cautionary tale of how credit controls have been used to curb inflation, we can look to Germany in the 1920s. Though the common story of German hyperinflation, drilled into us from our schooldays, is that the Weimar government printed too much money, things were not so simple. According to Hjamar Schact, the Weimar central banker credited with defeating hyperinflation, it was the liberalisation of private credit creation rather than government money creation that was the main driver of rapid price rises. This is a view that has been echoed by IMF researchers. Schact’s response was to use credit guidance to restrict credit creation, and allocate new money to preferred sectors, with his strict controls giving him the reputation of a ‘credit dictator’. As Werner argues, compared with the role of credit guidance, changes to the central bank’s interest rate appeared to be more for public relations than fighting inflation.

Though Schact’s credit policies enabled inflation to be brought under control by 1924, there was obviously a much darker side. While the common story goes that hyperinflation facilitated the rise of the Nazis, deflation under Schacht’s credit dictatorship and the subsequent unemployment, fuelled by government austerity, arguably played a bigger role in allowing Hitler to take power in 1933. With the great power of credit policies must come coordination with fiscal policy, to guard against the risks of deflation and unemployment.

No silver bullet for inflation?

So while credit controls could have a huge role to play in dealing with many of the issues we face, by allowing us to restrict financial flows towards things we don’t want (such as fossil fuels and speculation), and instead increase investment towards productive and socially useful purposes, they might not be the best way of dealing with inflation right now.

Really, what central banks may need to do is prioritise employment, even if this means putting up with a little more inflation for a little bit longer, and accept that there may be better tools beyond monetary policy for dealing with particular supply-side issues. It’s important to remember that inflation was frequently above 5% in Britain during the post-war economic ‘golden age’, and this may not be a problem today, especially if increases are being driven by stronger wage-growth. Especially when there are high levels of debt, as there is today, a bit more inflation is healthy and helps us repay it. Much more worrying is the threat of deflation and unemployment rearing its head as transitory inflation pressures pass, which the Bank of England could help bring into being by raising interest rates now.

In future blogs we will be looking at some of the other tools policymakers could be using to deal with specific price rises while avoiding the risks of tighter monetary policy.