Select Committee on Treasury Minutes of Evidence

Examination of witness (Questions 200-219)



  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.


  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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