MEMORANDUM BY PROFESSOR DAVID MILES, SPECIALIST
ADVISER TO COMMITTEE
THE MPC AND
THE OVERALL
MONETARY FRAMEWORK
Inflation in the UK dropped down to the centre
of the target range (2.5 per cent) in the middle of 1998. It dipped
below 2.5 per cent by the end of that year, and in the two years
since then inflation has moved down to, and then stayed around,
2 per cent. Given the historical track record, keeping inflation
close to, and generally slightly below, a figure of 2.5 per cent
is a major achievement. Expected future inflation also remains
low. Chart 6.8 on Page 68 of the February 2001 Inflation Report
shows the results of a survey of 27 forecasts of inflation (these
are made by independent research institutes and City institutions).
The range of forecast is remarkably narrow. The overwhelming majority
of forecasts are that inflation falls within the range 2.1 per
cent to 2.7 per cent. In other words, the MPC has succeeded in
persuading almost all outside forecasters that two years ahead
the most likely result is that inflation will be fairly close
to the centre of the target range. Medium and longer dated government
bond yields in the UK are now under 5 per cent. These prices strongly
suggest that investors in the UK do not expect inflation to be
significantly above the centre of the target range for the foreseeable
future.
Judged by what has happened to inflation over
the period since the Bank was given operational independence over
monetary policy, and by the influence this has had upon expectations
of inflation, the performance of the MPC looks extremely favourable.
But macroeconomic policy in the UK has been undertaken in a relatively
favourable environment—inflation has fallen to very low
levels in most European countries and in the US; in Japan it has
been negative for much of the last three or four years. Over the
past four years output has risen steadily in the UK, but has risen
far more rapidly in the US. Unemployment has fallen to historically
low levels, but the same is true in the US and unemployment is
now moving down in Europe.
Overall, the inflation and real economy performance
of the UK since 1997 has been very good, but not substantially
out of line with that of other industrial countries.
The greater achievement of the new arrangements
is not so much the macroeconomic outcomes but rather the dramatic
increase in the transparency with which monetary policy is formed
in the UK. Although members of the Monetary Policy Committee clearly
have reached different judgements on what policy is most appropriate
(though the scale of those disagreements is easy to exaggerate
and usually the debate is about whether interest rates should
move by 25 basis points or not move at all), there is admirable
clarity about the objectives of policy. Differences in opinion
are the result of inevitable differences in interpretation of
the facts, rather than differences over the objectives.
Many of the criticisms that one sees levelled
against the MPC strike me as unfair and often quite bizarre. For
example, it is common to hear it said that because inflation has
moved under the 2.5 per cent level and remained there for several
quarters, that the MPC is clearly failing in its responsibilities.
This criticism is unconvincing because the scale of the undershoot
is small and has been significantly influenced by events which
could not have been known at the time (for example the sustained
period of unusually strong sterling; the relatively benign inflation
environment in which most commodity prices have been weak; the
surprising degree of wage moderation given low levels of unemployment).
Had low inflation, and low expected inflation,
been achieved at the expense of high and rising unemployment and
falling output, that would have made the criticism of the MPC
carry some weight. But overall output has increased steadily,
unemployment continued to fall, employment continued to rise and
there have been no financial crises. It is very hard, I think,
to complain much about the way in which monetary policy has been
set given these facts.
THE FEBRUARY
2001 OUTLOOK
The major change between the February Inflation
Report and that produced last November is that in the intervening
period there has been a marked reduction in prospects of US economic
growth which prompted substantial monetary policy easing from
the US Fed. This has led the MPC to conclude that although its
central estimate of growth and inflation pressures are not substantially
different, the risks are now predominantly on the downside. The
inflation outcome chart on page 67 shows that whilst there is
little change in the expected level of inflation two years ahead
(compared with November), there is now a significantly higher
chance that inflation will undershoot. The big question is whether
what is clearly a slowdown in the US might become a recession
and, if it does, what the knock-on impacts on the UK might be.
There is major uncertainty on both factors. But looking at trade
patterns does reveal that what happens in Europe is significantly
more important for the UK economy than what happens in the US.
Furthermore, although all the European countries are open to trade,
the importance of developments within Europe for each country
are consistently far more important than what happens in the United
States. Even if output were to slow markedly in the US the direct
knock-on impact upon the UK is probably rather limited. Much less
clear is the impact on the UK were a recession in the US to trigger
a major downward adjustment in asset prices (most obviously in
equity prices). All this is discussed clearly in the Inflation
Report and it is what lies behind the asymmetric risks to the
projections for inflation and GDP growth.
The big question is "Should the MPC ease
monetary policy much more significantly now, so as to guard against
a substantial downward shock to demand stemming from a recession
in the US?" On the basis of figures 6.2 and 6.6 the answer
to this question is clearly No. Figure 6.2 shows that two years
from now inflation is rising: the MPC's central guess as to inflation
then is that is should have risen to the 2.5 per cent level and
be heading up. Chart 6.6 shows what the MPC's projections are
if interest rates were to be cut by another 50 basis points or
so over the next few quarters. If that were to happen the central
estimate of inflation is that it should be about 2.7 per cent
two years from now, and apparently rising.
There are enough uncertainties about what is
happening to demand pressures and inflationary pressures in the
UK to mean that a pre-emptive substantial further easing in monetary
policy now, to head off the effects of a US recession that quite
probably will not materialise, would surely be a mistake. As ever,
different indicators of economic pressures in the UK point in
different directions. The labour market clearly remains very tight,
with headline unemployment falling and labour shortages, especially
amongst skilled labourers, at high levels. Vacancies relative
to the unemployed are at high levels and recent data on wage settlements
suggests they picked up. The picture in the housing market is
particularly murky with the Halifax and Nationwide house price
indices suggesting very different trends in prices. The exchange
rate has also moved down by around 3 per cent relative to where
the Bank thought it would be in November.
Finally, it is clear that unless the spare capacity
in the UK economy is higher than a reasonable viewing of the data
would imply, then there needs to be a slowdown in the rate of
private demand in order to provide for the transfer of resources
to meet increases in public spending. There are very powerful
reasons why that spending is desirable given the high proportion
of it which is on infrastructure, or more generally on investment.
But unless it is to generate some overheating private sector demand
will need to grow less rapidly than in the recent past. Given
all these factors a powerful case can be made that any significant
further easing of monetary policy—unless it is triggered
by some clear signs of a recession in the US—is unwarranted.
19 February 2001
| 
