Examination of witnesses (Questions 160-179)|
TUESDAY 6 FEBRUARY 2001
160. I said that I thought that was a bit hard
on Professor Goodhart and, ". . . No, Professor Nickell did
not go through on the nod. It seems that academic politicians
are even nastier than the rough trade we engage in." Would
you have put it in those terms, Professor Buiter?
(Professor Buiter) I am not going to comment on that.
161. Mr Barrell?
(Mr Barrell) I would not have comments on people's
relative qualities as academics.
162. Sir Alan?
(Sir Alan Budd) No. To me this whole question is about
process, not personalities.
(Professor Buiter) I agree.
163. There is not an economist trade union like
the NUT which says that every teacher is as good as every other
teacher, so every academic is as good as every other academic?
(Sir Alan Budd) That is not how they normally seem
to behave, quite the reverse in my experience.
164. The new monetary policy framework, including
granting independence to the Bank of England, was intended to
help the Government better achieve its economic objectives. Do
you think they have been doing that?
(Sir Alan Budd) Yes, to the extent that it has allowed
the Chancellor of the Exchequer to concentrate on those matters
that he regards as at the heart of economic policy, without being
distracted by the sorts of crises that have been associated with
mishandling of monetary policy. It is perfectly possible for Chancellors
of the Exchequer to conduct monetary policy extremely well. This
system works very well, it has been highly successful, so there
has been no distraction, and to that extent, it must have greatly
helped the framework in which the Chancellor of the Exchequer
is trying to conduct his own policies.
(Mr Flemming) I would agree. As far as one can tell,
with some of the qualifications we made at the very beginning,
I think it has been a very successful devolution and distancing
from distractions, but it should not be associated, as I mentioned
earlier, with any sort of denial of responsibility, since it is
his system and it is his appointees.
(Professor Buiter) I fully agree. The system works
as designed, as intended, and it has worked well.
(Mr Barrell) I think both the monetary framework and
the fiscal framework have been sensible innovations in the macroeconomic
policy environment, and they should enable policy to be better
conducted. We have not tried either of them very hard so far.
So I would say we have been successful, but when one is successful
in a not very difficult exam, one does not learn very much.
165. In many people's eyes, the fact that the
target that is the centre of activity is an inflation target makes
people think growth and employment are being subjugated to the
inflationary interests. Is that correct in the way things work?
(Professor Buiter) I do not think so. First of all,
the inflation target is a symmetric target, which helps against
anti-inflationary heroics. Secondly, the Act itself says that
subject to the inflation target being met, the Committee is to
support the Government's other objectives. Growth and employment
are mentioned specifically. Clearly, if it can be done without
prejudice to the inflation target, the Committee is mandatedit
is not a choice the Committee make; it is obligedto stabilise
the real economy to the extent possible. The open letter procedure,
of course, is a further safeguard, because it makes it clear,
by recognising the possibility that it can deviate pretty far
from the target, and not therefore compelling the Committee to
do crazy things in order to always meet the target, no matter
what the shocks, that there might be circumstances under which
a temporary deviation from the target is not only acceptable,
but even desirable. The examples given in the background papers
involve mainly supply shocksthat is an obvious examplebut
there could be other circumstances. So I do not think that it
is wrong to have a single, nominal target, be it exchange rate,
price level, inflation rate, as the overriding target. This is
166. So how does the Monetary Policy Committee
work in comparison with the Federal Reserve, say, which has employment
as a much more explicit and apparently equivalent objective to
(Professor Buiter) Officially, the Fed has three objectives:
maximum employmentnot defined anywhereprice stability,
and interest rate stability. Nobody knows what that means. Basically,
the Fed has de facto something very close to what we do
here. It has been re-interpreted into being an inflation target,
possibly with slightly more emphasis on deviations of output from
capacity. De facto, I think it makes not much difference.
Whatever the letter of the law of Americaand the letter
is, I think, pretty strangethe practice is pretty much
(Mr Flemming) I think one has to recognise that the
language surrounding these institutions is very much a reflection
of the spirit of the doctrines of the time, and the Fed goes back
to the Keynesian era immediately after the war, also when in this
country, for instance, nationalised industries were being set
up and told to pursue the public good, without that being very
well defined. We have gone in generally, in both the public and
private sector, for much narrower definitions of objectives for
particular institutions. If the Fedinfluenced in part,
but now perhaps resiling a little, by monetarist doctrineswere
re-formulating it in America now, it would be much closer to our
position. If I could follow up on another of Professor Buiter's
comments, I think it is very important that when the 2.5 per cent
target was set, we were at 2.5 per cent. If we had been quite
a long way away, there is an important question about who should
determine the rate at which one tries to get back to the target.
If one is only 1 per cent away, probably it does not matter very
much, and it can be left essentially to the MPC, but if there
were to be a shock which was misjudged, not necessarily in a way
which was discreditable, by the MPC, and we ended up with inflation
at 5 per cent, although in the medium term monetary policy is
neutral and does not affect employment, in the short term, if
the MPC said, "We have got to get back there within a two-year
forecasting horizon", they would be tightening policy in
a way which would imply things for unemployment. I do not believe
that unelected officials should be making those trade-offs, and
it is rather importantand this is only a hypothetical situation,
but it would be desirable to clarify things and make it quite
clear that under those sort of circumstances the Chancellor should
be coming in and specifying a trajectory for getting back on target
within a timescale of his choosing. I think you will find that
the New Zealand contract does relate to a profile, and not necessarily
to holding a particular rate, and, as I say, we were lucky to
start from a sensible sort of rate to hold.
(Sir Alan Budd) I agree with that completely. As John
Flemming says, it has not happened, but it is easy to imagine
the conditions under which it should happen. I assume there would
at that stage be an open dialogue between the Monetary Policy
Committee and the Chancellor. The Chancellor might start it, but
you can imagine the Monetary Policy Committee writing a letter
saying, "Because of this shock"let us suppose
it is a price shock in the upward direction"we expect
inflation to exceed 3.5 per cent in the next year. If we are to
avoid that happening, we shall have to do the following, and we
believe the consequences for output would be as follows."
We are in some sense in your hands because if you tell us this
is not important, then by directing our policy towards the longer
term, inflation will exceed the range, we shall write a letter,
but this is on the understanding that this is the appropriate
policy for the economy as a whole, and that is, as John Flemming
says, a political judgment rather than a judgment which should
be left to the Monetary Policy Committee.
(Mr Barrell) Our European partners describe something
called "the macroeconomic dialogue", and I think our
colleagues are suggesting something a little along those lines.
Obviously, the Monetary Policy Committee has its role, and so
far there has been no test of whether its price target, which
is prime, conflicts with employment and growth. Of course, we
have had good employment prospects and good growth prospects.
I would look at the deflationary shock and ask questions about
that. If we had a very sharp deflation, when unemployment rose
very rapidly and growth was negative, the Monetary Policy Committee
would have the remit to get inflation back up to some sort of
target level, but it would also have to say to the Chancellor
as part of the macroeconomic dialogue, "Monetary policy cannot
do much about this on its own." I think the same is true
in the reverse situation. In the big disasters, policy has to
be in some sense co-ordinated, and we have to think monetary policy
is probably best at achieving medium-term price level stability.
Macroeconomic management through fiscal policy has some sort of
role in keeping output on track, but only some sort; it is very
limited, and microeconomic and other policies help with employment.
The three of them can go along together very happily as long as
nothing goes wrong, but as soon as something does go wrong, the
three sets of operators have to start talking to each other in
some way and design a package to get you back to where you want
to be. You could criticise the Bank for allowing deflation of
minus 5, but there might be very little it could do about it,
because it cannot cut interest rates below zero, and it might
have to honestly say to the Chancellor, "We need some help."
So I think the framework should also encourage dialogue and cooperation
between the two or three pillars of the system.
167. How much do you think the independence
of the Bank of England has affected the mix between monetary and
(Mr Barrell) It has perhaps made monetary policy more
reactive to fiscal policy, which is what one might expect if you
set somebody independent a target. A Chancellor who plans a fiscal
expansion might think, "I have a reason for this fiscal expansion
and I do not want monetary policy getting in the way." The
Monetary Policy Committee might see a Chancellor undertaking a
fiscal expansion and therefore pushing up demand and prices, and
their remit is to respond to that perhaps with higher interest
rates and, as a consequence, a higher exchange rate. So in terms
of the short-term reactions, we have probably got less coordination
of monetary and fiscal policy. That should in some sense be less
worrying than it might seem, because the objective of price stability
has now been separated out, Chancellors may take opportune decisions
just before elections and then reverse them, and it might be useful
to in some sense police that with an independent Monetary Policy
Committee. I think that was what was in the Chancellor's mind
when he set up the framework. We have had too much fiscal activism
and too much opportunism in our fiscal policy, and we want a framework
to reduce it.
(Professor Buiter) I disagree with my colleagues about
who should have the say in bringing inflation back to target following
a large shock. In my view, the open letter procedure would apply,
and the Committee would explain to the Chancellor why it happened,
what they proposed to do about it, over what horizon the Committee
plans to bring down inflation to target, and how all that is consistent
with the mandate. But the authority over rates is still with the
Committee. The only way to do away with that is for the Chancellor
formally to use the reserve powers and to take that power back.
I agree that under the current arrangements, both by changing
the target, which the Chancellor can do, and through the reserve
powers, you could operate in the way that my colleagues here suggest,
but I regret that; I would prefer both the power to change the
target to be very much more encapsulated in law rather than something
which can be done at the discretion of one person, and I think
the reserve powers have no place in a framework of operational
independence in the first place. So coordination of monetary and
fiscal policy, yes, is absolutely essential. There should be lots
of dialogue, exchange, and mutual support. But the ultimate authority
on what to do to rates should be with the MPC, not with the Chancellor.
168. But how has that balance between fiscal
and monetary policy, do you think, if at all, changed as a result
of the Bank of England's independence?
(Professor Buiter) I really do not know. I know what
the theory was in the past, but we know that the practice cannot
have been like the theory because the practice was often a complete
mess. I know how it works at present. There is an operationally
independent Committee with targets set by the Chancellor. The
same Chancellor is directing fiscal policy. There is clearly no
conflict of targets because they are both set by the Chancellor,
and information is shared freely. While we do not make binding
commitments to each other of the kind, "If you cut rates
by 2 per cent, we will give you 25 pence on the whatever",
I think that one learns the reactions of the other party, and
through a process of repetition and reputation buildingmutual
reputation buildingone ends up with something which looks
pretty much like a cooperative outcome. How it compares to the
old scheme I just do not know because I never operated under it.
(Mr Flemming) I wonder if I can make two points. The
first one is that the difference between me and Alan on the one
side and Willem on the other is not as great as he has suggested.
I was not suggesting that the Chancellor should take interest
rates into his own hands, although there might conceivably be
circumstances in which that would be appropriate. But, as Sir
Alan suggested, on the question of who takes the initiative, there
might be a letter from the Bank pointing out that it envisaged
a problem arising, even ahead of the triggering of a mandatory
letter, and indeed, it would be highly desirable if they did see
such a problem coming to alert the Chancellor. It is also possible
that the Treasury might pull its six-shooter before the Bank had
got its out of its holster. I do not think that would matter very
much either. What we need is the dialogue that was referred to,
and that applies equally to the monetary and fiscal policy question.
The fact of the matter is that the fiscal policy is adjusted relatively
infrequently, and the MPC meets very frequentlypossibly
too frequentlyand is therefore in a position to react,
and the Chancellor should know and be aware that if he pushes
things too far on the fiscal front, the Bank is likely to react
in a certain way. It is quite difficult actually. Learning by
doing might be costly; it might take too long. Therefore, I think
it could be helpful if the Bank were to possibly go a little further
than it has in developing in its research programme the sort of
features that its forecasting model had built in for fiscal effects
that would enhance the ability of the Treasury to anticipate reactions.
But it is very important that none of that should give rise to
any kind of commitment of the kind that Professor Buiter was referring
(Sir Alan Budd) I have nothing to add to what has
169. May I ask a related question on the process
of add-ons and trade-offs and who does what? I come from an area
which has recently had a number of factory closures, so I was
interested to read in Don Kohn's report that the agents' reports
are regarded as "useful" by the MPC. Obviously I had
hoped that the agent's report for my region is considered as useful
by the MPC, but do you think they take account of and have a remit
to really take account of the regional and business trends which
are identified within those reports from the agents, and if so,
how do they take account of those?
(Professor Buiter) They take account of them in so
far as they shed light on the pursuit of the nationwide inflation
target. They help build that picture. You cannot pursue regional
policies, but since the nation is the imperfectly aggregated sum
of the regions, regional information can often be helpful in allowing
one to reach a better view on what is necessary to pursue the
170. When we meet our agent in the region, we
will say to him, "We have these closures and we have these
problems about job losses. How can you feed that back to the MPC?"
The MPC should not just be looking at overheating in the south
and the south-east.
(Professor Buiter) No. It is for the nation as a whole,
the average performance in the nation as a whole. If it is very
dire in the north and over-heating in the south, you end up in
some sense being inappropriate for both, but still doing the right
(Sir Alan Budd) That is exactly correct. We listen
with great attention to what the agents have to say, because it
is very up-to-date information. In some sense it is unscientific
because they are not scientific samples. We understand that, but
nevertheless find them extremely valuable, because here these
people are talking to the businesses and to the firms and to the
unions in the regions. This is all extremely important information,
as Willem Buiter says. It is used to help us reach our conclusions
about what is happening in the nation as a whole.
171. Is there a mechanism for feeding that information
through to those who might have responsibility for regional policy?
Would you regard that as part of your remit if you are receiving
that information from the different agents?
(Sir Alan Budd) It sounds to me like a question either
for the Treasury or for the DTI.
(Professor Buiter) There are many ways of getting
information through to the regional agencies and national departments
that deal specifically with regional grants and other regional
172. Of course, the agents' reports are summarised,
are they not?
(Professor Buiter) Yes. That information is in the
(Sir Alan Budd) Also, the DTI, as you know, has a
regional system for information-gathering very similar to that
of the Bank's agents.
173. Following that on, of course, the sterling
area is itself a currency union; it is a single monetary area.
We often tend to forget that. People express the tensions and
conflicts of interest within that area in different ways: middle
England versus heartlands, rich versus poor, the overheating south-east
and peripheral north and west with different concerns. Professor
Buiter, you dealt with that by saying "We do our duty even
if it is inappropriate for any individual part of the country
or sector. Even if it is universally inappropriate, we do our
duty by the interests of the single currency area that the pound
sterling represents." But how do you balance this conflict
of interests? How can you be sure that there is some interest
which represents the interests of the sterling area as a whole
as opposed to all its parts?
(Professor Buiter) We do not target interests. We
target the nationwide inflation rate. We think we know, we have
some idea, as to how that is determined and how our instrument,
the interest rate, is related to the achievement of the target.
We do not have to take a view on weighting the balance of regional
or sectional or other interests. All we have to take a view on
is the transmission mechanism.
(Mr Flemming) I am not sure whether it is the current
academic view, but on the question whether, for instance, it is
only the national average unemployment rate that affects wage
pressures and thus inflationary pressures, there certainly used
to be a view that if there were disparities between labour market
tightness in different parts of the country, that tended to mean
that a given average was likely to be more inflationary. There
was an asymmetry that said that the pressures in the south-east
would have a bigger impact on wages and inflation nationally than
would the percentage point below the national natural rate or
whatever in another part of the country, and therefore, if there
is more dispersion, there is liable to have to be a higher level
of interest rates and a higher level of unemployment nationally
in order to achieve the target. That is something where, as Professor
Buiter says, under the present arrangement, the Committee simply
has to grit its teeth and do its duty, and this reinforces the
fact that not only do we need regional policy in order to solve
the problems of the regions, but that a well-designed regional
policy might actually improve the trade-off between inflation
and unemployment nationally. But it is beyond the scope of the
Monetary Policy Committee to undertake that regional policy itself.
174. Taking into account the discussion that
there was earlier about the exchange rate, one was left with the
feeling that it was very much the view of you all that a high
exchange rate was a part of counter-inflationary policy, and that
therefore it was a balancing item, that if there was a considerable
change in the exchange rate, it would automatically have to trigger
a rise in interest rates, unless there were some very unusual
circumstances. Did I get that picture correctly?
(Sir Alan Budd) I do not think it was what I was trying
to say. I certainly agreed with the first part that a "high
exchange rate" is part of the environment in which the Monetary
Policy Committee is setting its own instrument, which is interest
rates, and it will take that into account when setting interest
rates and deciding what level of interest rates is appropriate
to achieve the inflation target. So it is a very important part
of the information that it is looking at. On your question of
how the Monetary Policy Committee would respond to a change in
the exchange rate, as I am sure you have heard many times from
other witnesses from the Monetary Policy Committee, that would
depend very much on their assessment of why the exchange rate
had changed in the way it had and what other things were going
on. So it would be wrong, I think, to imply any automatic link
175. The Deputy Governor has given a very clear
signal that he would regard a change in the exchange rate as producing
an automatic compensating move in interest rates.
(Sir Alan Budd) I am most surprised. I was going to
quote the Deputy Governor as someone who goes to great lengths
to explain that it does matter why the exchange rate be changed.
(Professor Buiter) It depends which Deputy Governor
you are talking about.
(Sir Alan Budd) I was referring to Mervyn King. I
am interested that you got that message from him. That surprises
176. It was not from him. It was Mr Clementi.
(Sir Alan Budd) I am sorry. I had forgotten.
(Mr Flemming) Being possibly the less academic, he
may have been less explicit about his ceteris paribus assumptions.
Clearly, in almost any economic model, a lower exchange rate would
make for a higher inflation rate, other things being equal, and
would therefore make it appropriate to move interest rates. But,
of course, it is very unusual for the exchange rate to move without
something else having happened. Indeed, it would be a great mystery,
and we would try to resolve that mystery as fast as possible,
and then there would be at least two factors to take into account.
177. If the Chancellor chose to use tax and
spend to increase demand in the economy, do you think that would
trigger an automatic correction upwards in interest rates?
(Sir Alan Budd) It is again a question of what else
is going on. If compared with what the Monetary Policy Committee
had believed was the state of fiscal policy when they last set
interest rates, if between that occasion and the next occasion
there had been something which was quite clearly a relaxation
of fiscal policy, that again would be a very important factor
in their considerations. All other things being equal, again,
it would tend to move them in the direction of tightening monetary
policy to compensate, but one would want to know (a) was this
clearly a fiscal relaxation and (b) what other news was there
coming along at the same time? These are all pieces of information
that feed into the decision-making process.
(Mr Barrell) One might take the current situation
as a good example, not because of anything that is happening,
but many economists would agree that we are round about at full
employment and round about at capacity, and the Monetary Policy
Committee have been given the remit by the Chancellor to keep
inflation within certain bounds. So if the Chancellor were to
adopt an expansionary fiscal policy and nothing else was going
on, that would put pressure on demand, would put pressure upwards
on prices, and the Monetary Policy Committee's remit from the
Chancellor is that it should respond by putting up interest rates.
The constitution that has been written has that reaction written
into it, so one cannot criticise the Monetary Policy Committee
for that reaction: that is what it has been told to do.
178. It was pointed out earlier that the inflation
target looks as though it is going to be achieved or more than
achieved, and that has been a fairly consistent feature. Do you
think the Monetary Policy Committee could have done more for growth?
(Sir Alan Budd) If by growth you mean in some underlying
structural sense, which is what determines growth in the long
term, it is not completely clear what they could have done. The
interest rate is not generally an instrument that changes the
underlying growth of the economy. That is to do with a whole set
of micro policies of one sort or another, including those, of
course, which this Government and previous governments have introduced.
179. Supposing I meant something else by growth?
(Sir Alan Budd) If you had meant could the economy
have been run during this period at a higher level of capacity
or lower level of unemployment, after the event that appears to
be the case. There has been a remarkably low level of unemployment,
but that is admitted right at the beginning, that since inflation
has been lower than was expected or it was required to be by a
margin, there would be an alternative state of the world in which
presumably unemployment would have been slightly lower and inflation
would have been higher. It might well have been accelerating,
which would have given a policy problem. That is in some sense
what happens if errors are made that can be revealed to be errors
after the event. Equally, there can be errors on the other side,
but the margins here actually experienced are extremely small.
That is the important point. The extraordinary thing is that they
have kept so close to their target while unemployment has been
so encouragingly low.