Examination of witness (Questions 200-219)
MONDAY 26 FEBRUARY 2001
MR DONALD
KOHN
200. Is that not likely to generate some sort
of bias to London factors being predominant?
(Mr Kohn) I would hope that they were not making monetary
policy based on what they saw in London. I would hope they were
making monetary policy based on what they were learning about
the entire UK economy. In my observation that was certainly true,
that is I did not hear references to the London economy as dominating
their considerations of national economic policy. I think it is
very, very important that they have contacts in the regions, that
the agents act as contacts with the regions. I think it is important
that the MPC members not be overly influenced by what they see
going on around them in London but I did not notice anything like
that.
201. Which do you think is most important to
the MPC when it is making its deliberations, the individual regional
reports or the assimilated national picture?
(Mr Kohn) I think it is the assimilated national picture
and I think it has to be the assimilated national picture. The
MPC is given a remit which is national inflation, RPIX for the
country. They need to determine what they need to do with their
short term interest rate in order to hit a national economic goal.
I think they are forced by their remit, appropriately so in my
view, to look at the national picture and the regional picture
is important, the sectoral picture is important, as it illuminates
the national picture. They have one instrument and one goal and
they cannot really use it to accomplish something for the regions
if that is at variance with the national, so the national data,
the national picture, appropriately dominates their discussion.
Mr Plaskitt
202. You said something very interesting when
you were talking about how MPC members arrive at their conclusions
in the Inflation Report when they are putting it together. You
say in your report that a number of members perceived some game
playing. What game are they playing?
(Mr Kohn) Remember when I witnessed this Inflation
Report round, it was a round of ten meetings, I think, give or
take a few, and the inflation forecast was built from a series
of discussions of many, many factors that would go in to the overall
picture. Each factor was considered separately. So the Committee
would discuss factor A; then it would go on and discuss factor
B and then factor C and factor D and at the end of the day they
would add all these factors up and see what the national picture
would look like, what the end result was. I think some members
perceived that other members when they came to factor A were not
necessarily giving their view on exactly what they thought would
happen with factor A. They were giving their view on factor A
with a view towards how that would all end up adding up in the
end, that they had a view as to what they thought the inflation
forecast should look like and they were using these individual
building blocks to make sure that the total came out the way they
thought it should come out, and not necessarily giving a totally
objective view on each individual building block. I did not actually
observe that, in part because I do not know what is going on in
people's minds and also in part I was observing one round and
not a series of rounds over time. I think, as I understand how
the process has changed, that should be much less of a concern
right now. Among other things there is more attention given both
to the overall forecast, as I understand it, so you do not have
to do that, you will get plenty of time to talk about the overall
forecast. I was struck when I observed the process how little
time was spent talking about the overall forecast. There was a
lot of time spent about this factor A and how it was going to
affect the forecast and B and C and D and then each time you saw
the forecast, but there was not as much time as I would have been
comfortable with stepping back at the end and saying "Now
let us see where this all came out. How does this make sense in
the context of the major forces driving the UK economy, all this
building block business". Now my understanding is, firstly,
there are many fewer building blocks, and secondly they try to
identify the three or four major issues.
Chairman
203. Is this in response to your criticism?
(Mr Kohn) Yes, so they say. I am sure it is. They
identify the major building blocks and they take much more of
an overview of the whole forecast. If I was a member and I had
much more time for an overview and I had a view as to where the
whole forecast ought to come out, I do not necessarily have to
shade my views on one of these building blocks, I am going to
get enough opportunity at the end to voice my view to try and
influence the forecast, influence the thing. I think there is
less of that now, I suspect there is less.
Mr Plaskitt
204. That is encouraging. Was that process in
some way unique to this body of people making these decisions
or is it a symptom of committees and just the way they arrive
at their conclusions?
(Mr Kohn) Any forecast has to be built up of the building
blocks. It has to be consistent. You have an overall forecast
and you obviously have a set of assumptions and building blocks
that give you the building that the overall forecast is. I think
any forecasting exercise is going to go both up and down at the
same time. Some forecasting exercises, remember the old monetarist
forecast where they just took the money supply and forecast GDP
and they just concentrated on the building without really worrying
about the blocks that came in. Other forecasts tend to build it
from the bottom, from the foundation and from the bottom up. I
think any good forecasting process needs to go both ways. You
need to look at the overall forecast and see if that makes sense
given what you think you know about the economy and the major
forces driving. One way of knowing whether that makes sense is
seeing whether the individual building blocks make sense in terms
of what that implies about consumption and investment and trade
and that sort of thing. On the other hand, looking at those individual
building blocks, it would be possible to look at consumption and
investment and trade and inventories and put together sensible
assumptions for each of those and come out with a building that
no-one would be able to live in. I think it has to be a two way
process. My observation was there was not enough of the top down.
There was not enough of the "let us stand back and look at
this whole building and see whether anyone will want to live in
it"—
205. You think that is better now.
(Mr Kohn)—but I think that is better now.
Sir Michael Spicer
206. I wonder, Mr Kohn, if we could turn to
some of the interesting things you say about the inflation target.
As you know, by statute the MPC is bound to treat the inflation
target as an override over other considerations. My first question
is do they do so? Are they taking the inflation target seriously?
(Mr Kohn) Yes, in my view they are taking the inflation
target very seriously. The entire forecast round that I witnessed
was very much orientated to the inflation forecast, the 2.5 forecast
two years out. The discussion was very much orientated to that
forecast. That forecast is an intermediate target. The remit of
the MPC, as you know better than I do, is that inflation should
be 2.5 per cent, it does not say keep your forecast at 2.5 per
cent it says keep inflation at 2Ö per cent. That is a very
sensible intermediate target. When inflation gets away from 2.5
per cent you might not want to take it back right away because
it would be very jarring to the economy. Firstly you probably
could not do it given the lags in policy and, secondly, if you
tried it would be very jarring to the economy. It seems to me
an inflation forecast is a very sensible intermediate target for
an inflation target. I did not witness anything that would suggest
to me that they were not taking that target very seriously.
207. I think it is the nature of the forecast,
certainly your own criticisms or comments on the forecast, which
I am interested in if one takes the fact that there are a variety
of different profiles, risk profiles, particularly between forecasts
and yet each time, bang on, they hit the 2.5 forecast. If we take
the current Inflation Report on page 66, they have, rather unusually,
incorporated two variables on interest rates - and we might come
on to the question of why they do not vary interest rates more
in a moment but in this case they have varied interest rates—and
again the risk profile is very different between the two things
and yet you get bang on 2.5 at the end of it all. It is a little
bit suspicious as to whether this 2.5 per cent forecast is not
spurious and you yourself, it seems to me, in your report were
concerned about this.
(Mr Kohn) First of all, the difference in the interest
rates in the two forecasts is the interest rates that were in
force at the time. The reason they have a lower interest rate
is because they have chosen the interest rate and they are making
the forecast at the current interest rate. I think they are correct
to focus on an inflation forecast as an intermediate forecast
for achieving inflation and an inflation target. If I had a concern
it was perhaps the focus on 2.5 two years out and that a constant
interest rate was too rigid, that you might want to be concerned
about inflation before and after two years out. I can imagine
a situation in which this did not print at 2.5, but was 2.7 as
it was a few months ago, or 2.3, even a little higher or lower
than that but there were good reasons not to move interest rates
right now to get that target at 2.5 in two years out. Reasons
might be uncertainty about how the economy would develop over
the next two years. Reasons might be a sense of risk very much
on one side rather than the other that they wanted to take a little
bit of account of in their policy setting so they would not aim
bang on at 2.5. I can see a number of reasons why you might deviate
from 2.5 two years out and still be consistent with trying to
achieve the Chancellor's remit of hitting your 2.5 target. I was
not worried that they were not taking this too seriously. In my
observation they were taking it very seriously. If I had a concern
it was that they might be taking it more seriously than was optimal
than under some circumstances, and that letting this deviate from
2.5 would be perfectly fine depending on the circumstances (though
not too far obviously).
208. I understand the argument, but I am not
as confident as you are about the objective. On the forecast it
does seem to me from what you have just said to point a little
bit towards the forecast being some sort of justification for
the policy stance rather than a real forecast because you have
made the point, first of all, about the length of time issue but
also the point about taking interest rates as a given. Clearly
interest rates are not going to be necessarily fixed for a period
of two years. If one's real aim is to get policies associated
with a real forecast, then surely they may not be going about
things the right way, and the fact they hit or are below the target
may be a fluke rather than to do with accurate forecasting and
associated policies of accurate forecasting.
(Mr Kohn) As you know, I discussed the constant interest
rate assumption at some length in my report and for the reasons
you state, and even for some others, it is not a terrific assumption.
Everybody knows that interest rates will not be constant. The
models and the forecasting techniques used here are built out
of a world in which interest rates are not constant and so the
relationships they embody are consistent with the world in which
interest rates will lift off over time and the Committee may have
some views as this thing passes through 2.5 as to where interest
rates are likely to evolve, but the difficulties, it seemed to
me, of deciding what the alternative assumption would be were
very, very severe. How do I draw a path for interest rates for
the next two years? How do I reach an agreement among nine individually
accountable members of the MPC about what that path is likely
to look like? If there is disagreement on that that will feed
through into the inflation forecast and make it much more difficult
to interpret the inflation forecast and table 6.B that talks about
deviations from the inflation forecast. I reached the conclusion
that the constant interest rate was a bad assumption, but I could
not come up with something that could do better. It is obviously
an assumption, it is very clearly an assumption. Most other central
banks that publish inflation reports like this use the same technique,
I think for lack of seeing something better to do, and the fact
that this is a report by the Committee just makes it all the harder
to say, "We think interest rates are likely to evolve in
the following way over the next several years ..." It would
be very very hard to determine what that evolution would be.
209. Is that not tantamount to saying that almost
by definition the forecasts are going to be wrong?
(Mr Kohn) Yes, yes, but they recognise that the forecasts
will be wrong. Forecasts always are wrong. As economists our knowledge
of the economic structure is very limited, I think, and things
are changing all the time. We are constantly being surprised by
shocks to the economy which we had not anticipated or interactions
we had not anticipated. I am absolutely certain that the forecast
will be wrong, just as I am absolutely certain that the forecast
we provide to the FOMC will be wrong. The FOMC points that out
to us from time to time!
210. That is a very interesting and straightforward
answer. Does that not mean in practice that what they do is what
the rest of us do which is look out the window and see what has
changed and make a judgment based on the basis of unemployment
figures today or inflation yesterday, and they are not producing
much better expertise or foresight or insight than the rest of
us could do as politicians, say?
(Mr Kohn) I will not speak to your own forecasting
ability, but I do not think that is what is happening. I think
they are making monetary policy based on the best forecast they
can make.
211. Not the best because the best would be
with proper variables.
(Mr Kohn) The best forecast they can make under this
assumption and if that deviated significantly from 2.5 they ought
to change the rate that they are using in order to make the forecast,
so I do not think they are just reacting to the incoming data.
The incoming data are very important and the incoming data colour
their forecast, but I think every central bank tries to be forward-looking
in its monetary policy given the lags. I know that we certainly
do at the Federal Reserve. You realise the limitations and some
times you are more uncertain than other times and at those times
you tend to be a little less forward looking and a little more
reactive in your policy, but you are always as forward-looking
as you can be given the lags. If you are just reactive you are
going to end up putting cycles into the economy rather than smoothing
them out. I think they are trying to be forward-looking given
the limits of what they know. Given those limits, I think the
discussion of skews, the discussion of risks is among the most
important discussions in the Inflation Report because that tells
you where they are a little more uncertain than other places,
where things could go wrong if they do not come out where they
are. I think it is that discussion of the risk to the forecast
of their uncertainty about how the forces are going to work through
that should carry almost the most information in it because things
will not turn out the way they expect—that is absolutely
guaranteed—and if you are in the market or in the public
trying to anticipate what the MPC are going to do, reading their
discussion of the risks, of the skews, of the possibilities that
things will not turn out as they expect, should be among the most
interesting things they produce.
212. The worry is that there is a spurious credibility
about the whole thing that does not exist in other forms of forecasting
and policy-making which gives to this kind of exercise a credibility
which it not only does not deserve but which it is dangerous to
have. My last question about that is you yourself clearly in your
report had some worries about this because you come up with five
alternative types of ways of going about forecasting. My last
question is really this: do you have any preference amongst those
five approaches as to what you would advise the Committee to continue
with?
(Mr Kohn) I would rule out the first three approaches.
The first approach was not to have a forecast at all but simply
discuss the forces at work. As I just said, I think that discussion
is probably almost the most valuable thing the Committee can do
to talk with the public and the markets about what is going on.
It is the discussion of the forces at work that gives you a sense
of what they are worried about and what they see developing. Still
the forecast itself serves a number of valuable functions. Internally
it helps to focus the Committee's own discussion, the process
of coming up with a forecast is very valuable to the Committee,
it forces them to talk about now the major issues facing them
and try and come to some agreement about where those issues are
going. The process of coming up with a forecast is important to
them and I think it is an important way of communicating, of disciplining
them in terms of the 2.5 and of communicating to the public and
of their accountability. I think the fact you can say to them
"You keep forecasting that inflation is going to return to
2.5 and it has not for the last two years" is an important
question for you to ask them as part of the process of accountability.
I think a forecast is important. I think they ought to have a
forecast. I do not think it should be a staff forecast. After
all, it is the Committee that is accountable for hitting the target
so the forecast ought to be associated with the Committee, the
Committee is making the decisions. The forecast should help to
explain the Committee's decisions. I think the forecast ought
to be the Committee's in some form or other. A staff forecast
to me would not be a productive way to go on this and I would
be concerned it would inhibit the staff, public forecasts would
inhibit the staff from giving them the best information that they
could. A Governor's forecast or a Bank forecast I think also suffers
from the idea that it is not the Committee's forecast, it is the
Committee that is making the policy decision, it is the Committee
that needs to explain itself. That leaves me with two at the end:
a majority forecast and a median forecast. I could not choose
between the two. I think what you have got now is a little bit
of both to tell the truth. I think you have got something they
call the centre of gravity and the centre of gravity you could
think of as a median forecast, the middle forecast, the forecast
around which the other forecasts cluster. I think it is more than
just the median, I think it is the forecast that most of them
agree on. I think it tends to line up with the majority of the
Committee as well. I think you have a little of both now and that
is not a bad way to go.
213. You think that is about the right mix?
(Mr Kohn) I think it is the right mix but I also think,
as I voiced in my report, that they need to keep defining this,
keep worrying about it and keep pushing out the public understanding
and their own understanding of exactly what it is they are producing.
Mr Beard
214. The Bank staff have to subscribe or work
for both the quarterly review and the Inflation Report.
(Mr Kohn) Yes.
215. Does this put excessive pressure on them?
(Mr Kohn) I think what puts pressure on them is the
monthly periodicity of the meetings. The quarterly Inflation Report
is a little bit of an issue but not so much of one. I think being
involved every couple of weeks with this thing coming up, that
does put pressure on the staff. I think they move to widen participation
in the meetings and to bring more people in. They are better staffed
up now than they were when I was there. They have filled many
of their vacancies, so I think things are improving in that regard.
216. Do you think the pressure will ease now
the Bank has decided to not publish the quarterly bulletin and
the Inflation Report at the same time?
(Mr Kohn) I do not know how much that will help. I
am not familiar enough with the process of publishing the quarterly
report to answer that.
217. Do you believe that the resources of the
staff in the monetary analysis division are being fully utilised
by the MPC?
(Mr Kohn) I think they are being better utilised now.
When I was there some of the staff resources felt that their expertise
was not being adequately utilised, that, as I say I think at the
end of my report, in some sense they were not being asked for
all the analysis they could give. My understanding is they are
being asked for more analysis and that they are being utilised.
At the same time, the Bank is working to build the expertise of
the staff. They have staffed up, as I understand it, so there
are more folks around. They have instituted some things on pay
and promotion to try and keep people around, the staff retention,
so they have more experienced folks. The more experienced folks
they have around the more they will be able to take advantage
of their expertise, so I think things are moving in the right
direction there as I understand it.
Mr Cousins
218. Do you think that the fact there are so
many meetings of the Committee, that it meets every month, actually
has an effect on its decisions?
(Mr Kohn) That is they tend to move in smaller steps.
I do not think it should. I think they ought to decide where rates
need to go and move in that direction. Perhaps a monthly meeting
means that they can move in smaller steps to get there but my
guess is that it is not an important factor. I would not guess
it was important as compared with, say, eight meetings a year
rather than 12. I am not talking about two meetings a year or
something like that but going from 12 to eight or 12 to ten, I
would not guess that was a major issue.
219. Your report gives the impression that the
meetings, particularly the assessment meeting, the briefing meeting
prior to the actual rate setting meetings is actually quite a
political process in which members of the Committee with various
ideas about how they want things to go are trying to get the high
ground in terms of their particular argument.
(Mr Kohn) Actually I witnessed that more in the inflation
forecast rounds, that is in the process of putting together the
forecast the Committee members would try to position the forecast
as it was developing—this was how some Committee members
saw other Committee members behaving, I should add—to be
tilted in the direction that they wanted it to go. I did not really
witness that so much in the briefing right before the MPC meeting,
the pre-MPC briefing. That was pretty much a question of the staff
and the agents giving information to the Committee, the Committee
asking questions about that information to be sure but I did not
note that the questions necessarily were skewed towards a particular
interest or the particular policy outcomes that the Committee
members might be looking for. I would not, I guess, be surprised
if that happened but that is not the sort of thing that I observed
there.
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