Select Committee on Treasury Minutes of Evidence

Examination of witnesses (Questions 160-179)



  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.

Mr Beard

  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 mandated—it is not a choice the Committee make; it is obliged—to 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 shocks—that is an obvious example—but 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 proper.

  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 inflation control?
  (Professor Buiter) Officially, the Fed has three objectives: maximum employment—not defined anywhere—price 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 America—and the letter is, I think, pretty strange—the practice is pretty much like ours.
  (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 Fed—influenced in part, but now perhaps resiling a little, by monetarist doctrines—were 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 important—and 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 fiscal policy?
  (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 building—mutual reputation building—one 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 frequently—possibly too frequently—and 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 to.
  (Sir Alan Budd) I have nothing to add to what has been said.

Judy Mallaber

  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 nationwide target.

  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 thing.
  (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 issues.


  172. Of course, the agents' reports are summarised, are they not?
  (Professor Buiter) Yes. That information is in the public domain.
  (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.

Mr Cousins

  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 between them.

  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 me.


  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.

Mr Cousins

  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.

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