III Assessing the Monetary Framework
19. The various components of the monetary framework
are intended to ensure the transparency and accountability necessary
to maintain the credibility of the MPC. This credibility is important
because, if the policy framework is to succeed in the long term
then, as the Chancellor told us in our previous inquiry, it is
necessary to get "an all party consensus on the importance
of the change that was made in monetary policy."[29]As
Professor Minford explained to us at the time, "having an
independent central bank is not sufficient condition for inflation
control unless it is underpinned by political consensus."[30]
It is perhaps a measure of the success of the monetary framework
that there is now broad political acceptance of it.
THE TRANSPARENCY OF THE FRAMEWORK
20. The monetary framework set up the Chancellor
is extremely open and transparent; indeed Sir Alan Budd told us
that he believed it was "possibly the best system in the
world for setting monetary policy."[31]
Outside of periods when inflation is overshot or undershot by
more than a percentage point (necessitating a letter from the
Governor to the Chancellor), the main vehicles for explaining
monetary policy are the minutes of the monthly meetings, the quarterly
Inflation Report and the subsequent hearings held by this Committee.
Professor Minford summarised the general perception on the transparency
of the framework in his evidence to our last inquiry. He "welcomed
the extreme transparency whereby you get individual members of
the [MPC] along, they can say where they stand, you get a well
informed public debate where all the participants who have a vote
can be assessed and therefore it reduces the uncertainty surrounding
monetary policy."[32]
MPC meeting minutes
21. The MPC meeting minutes are notable for the clarity
with which they explain potentially complicated policy decisions.
Nevertheless a number of witnesses, in particular Professor Buiter,
advocated greater individual accountability in the minutes. He
suggested inserting "at the end of the minutes where the
votes are recorded a short paragraph written on the day the vote
is taken ... explaining why each individual member voted that
way."[33]
However, when we put this idea to the Governor he said he was
concerned that "there is a real danger" in such an approach
"that you do get into a situation where the individual personality
impedes what I believe is a very well working process ...You would
focus the thing on personalities rather than on the elements in
the debate."[34]
We do not see the need for individually attributable explanatory
paragraphs. We believe that differences of view between MPC members,
and their wider thinking, can be explained in public, including
in our evidence sessions. We return to this issue in paragraph
43.
22. The Bank has also taken additional measures to
heighten public awareness about monetary policy and to explain
the decisions of the MPC. In April 1999, following a recommendation
of this Committee, the Bank published a paper on the transmission
mechanism[35]
and its suite of forecasting models. Members of the MPC also make
numerous speeches around the country. In addition, the Bank has
introduced more innovative measures such as a monetary policy
competition for schools in conjunction with the Times newspaper.
We commend the Bank on the way in which it has sought to disseminate
information on the policy and actions of the monetary policy committee.
However, as we noted in paragraph 10, public expectations of
the inflation rate remain approximately a percentage point above
the target and hence we would encourage the Bank to continue to
think of ways in which they can broaden the reach of their information
campaign.
The Inflation Report and forecast
23. When the Inflation Report was first introduced
by the then Chancellor Norman (now Lord) Lamont, its aim was to
"produce a wholly objective and comprehensive analysis of
inflationary trends and pressures."[36]
The Bank of England Act set out more specific guidance for the
Report stating that for each quarter it should contain "a
review of monetary policy decisions published by the Bank ...
an assessment of the developments in inflation in the economy
of the United Kingdom and an indication of the expected approach
to meeting the Bank's objectives."[37]
The Act also states that "No report under this section shall
be published without the approval of the Monetary Policy Committee."[38]
The Inflation Report has thus become the main vehicle for explaining
the underlying thinking of the MPC in depth.
24. Possibly the most important analysis used in
the Inflation Report to elucidate the future approach of the MPC
to meeting its objectives is the inflation forecast. The Bank
recently published an explanation of the forecast process in the
Inflation Report. The Bank explained that "forecasts are
central to the conduct of monetary policy given that it takes
time for interest rates to affect inflation."[39]
The inflation forecast fan charts show "the best judgement
of the Committee as a whole about inflation and growth prospects,
conditional on assumed interest rates." However, the article
cautions that "this may not be the best judgement of each
individual member of the Committee." It also emphasises that
the link between the fan chart and policy is "not mechanical."[40]
25. As the arrangements for the MPC have bedded down
and the economic environment has changed, the increasingly disparate
views among MPC members have meant there have been occasions when
opinions on the future outlook for inflation have differed significantly.
Sir Alan Budd highlighted such an occasion in May 2000, when "the
fan charts and what is known as the best collective judgement
gave a path for inflation which had inflation at the end of the
two year period at the target of 2.5 per cent. But ... individual
members ... differed from that central view ... [and] if you summed
these disagreements ... there appeared to be ... some people who
thought that inflation in two years time would be three per cent
and some who thought inflation in two years time would be two
per cent."[41]
This difference of views amongst MPC members has up to now been
accommodated in the form of a table in the Inflation Report. However,
as Mr Bootle told the Committee "increasingly it is becoming
clear how difficult it is to present a single view of the future
in this way."[42]
There must therefore be a concern that the central view of the
inflation forecast (illustrated by a deep red middle band in the
fan chart) in fact represents the views of a minority (or possibly
even none) of the MPC members. It is doubtful that such an outcome
enhances the transparency of monetary policy, a point Mr Kohn
noted in his report to the Court of the Bank on the monetary policy
processes of the Bank of England: "the forecast round and
Inflation Report perhaps may not be as helpful as they might be
to the Committee, or to the public, the Parliament, and the markets
in understanding, predicting, and judging policy actions."[43]
26. Our witnesses had a number of possible solutions
to this problem. Mr Bootle suggested "having a forecast of
the future from the Bank staff and it being quite open and clear
that this is not necessarily, as it were, the central view of
the Committee as a whole."[44]
Mr Kohn set out five possible alternatives in his report, but
recommended only two to us: "a majority forecast and a median
forecast."[45]
He did not, however, choose between the two, but thought that,
following his recommendations, the Bank now used "a little
of both now and that is not a bad way to go."[46]
Professor Charles Goodhart, a former MPC member, has also considered
this problem in a recent paper.[47]
He concluded that the best solution was "to make the Governor
the sole author of the Inflation Report, but approved by the MPC."[48]
However, the Governor rejected this proposal, arguing: "I
do not think a Governor's forecast would be worth anything. It
would certainly be worth no more than a staff forecast in terms
of its impact on the policy."[49]
27. We agree with Mr Kohn that "the inflation
forecast and Inflation Report are key elements in making policy
under the inflation target set by the government and in explaining
the policy to the public."[50]
We also note Mr Kohn's point that "the forecast round and
Inflation Report may not be as helpful as they might be".
We recommend the MPC review the current arrangements.
The unchanged interest rate assumption
28. The inflation forecast makes the assumption,
as Professor Bean told us, that "interest rates stay unchanged
over the forecast horizon."[51]
This assumption has been criticised by the IMF who noted in a
working paper in December 1999 that the Inflation Report "appears
to lack transparency and credibility in relation to its inflation
forecast."[52]
Our expert witnesses also questioned whether such an assumption
was credible. Mr Flemming explained to us there have been occasions
when the "chart of inflation expectations was on target for
two years out but ... it was fairly clear that the next ... quarter's
forecast was going to show the inflation rate being considerably
above target. Therefore it would be natural for someone to draw
the conclusion that interest rates were going to have to change
within the next quarter."[53]
Such a position clearly calls into question the credibility of
the assumption of unchanged rates.
29. Mr Flemming's solution to this problem was to
assume that inflation would be at the target range and then require
the MPC to "publish with wide dispersement probably a trajectory
of short-term interest rates which we think is compatible with
delivery."[54]
However Sir Alan Budd warned that the difficulty with this approach
would be "getting the Monetary Policy Committee to agree
on the path [for interest rates.]"[55]
Mr Barrell also pointed out that the Bank of England as a central
bank was working under different constraints from independent
economic forecasters. They therefore faced the problem that "if
the central bank says interest rates will go up in six months'
time everybody will say, 'Why don't you do it now?'" Mr Barrell
thought that was "a very difficult question to answer."[56]
30. Professor Bean explained that the MPC's interest
rate assumption was a "benchmark" and that the MPC undertook
"an extensive examination of the alternative interest rate
profiles that might generate particular inflation profiles."[57]
Mr King added that the MPC "look at the fan charts and the
different levels of interest rates ... [and] set interest rates
at a level such that the fan chart looks as if the central projection
is coming back to 2.5 per cent." He emphasised that "what
matters to most members of the Committee is the balance of risk."[58]
We recognise that there are a number of theoretical criticisms
of the MPC's forecast assumption of unchanged interest rates.
However we think that it provides the most easily understood framework
for assessing future policy developments.
THE INFLATION TARGET
31. The Bank of England Act states that the Treasury
shall define "what price stability is taken to consist of."[59]
To date the Chancellor has defined price stability as an annual
increase in RPIX of 2½ per cent. However, looking ahead it
is possible that the Chancellor may wish to change either the
level or measure of the inflation target. Our expert witnesses
were divided on whether he should do this. Mr Flemming thought
that developments in the economy "might make it appropriate
to consider lowering it now."[60]
Mr Barrell agreed telling us that "2.5 per cent cannot really
be described as price stability in the medium term and there would
be a strong case for reducing it to 1-ish for the next parliament
without there being a significant tightening of monetary policy
during that process."[61]
Professor Buiter, however, did not think it would be a good idea
to reduce the target; he warned that "changing the target
should only be done very infrequently; otherwise the Chancellor
by repeated changes in the target can regain discretionary power
over monetary policy."[62]
He therefore preferred to wait to "revise the target when
Britain joins EMU," if that were to occur. Sir Alan Budd
shared Professor Buiter's view "about the desirability of
stability in this inflation targeting activity," but pointed
out that "we know from experience that 2.5 per cent on the
retail price index excluding mortgage interest payments seems
to be equivalent to about 1.5 per cent on the harmonised index
of consumer prices ... so we are not far from the 1 per cent the
European Central Bank has in mind."[63]
We would like to see more commentary in the Inflation Report
on UK inflation as measured by the Harmonised Index of Consumer
Prices.
32. The Governor agreed with Professor Buiter that
if the target "were changed too often, that would actually
damage the process," although he acknowledged that "there
would come a time when it would be sensible to review it seriously."[64]
He thought it would be "premature"[65]
to change the target at the moment because "the arrangements
are still bedding down."[66]
We do not think that at present it would be appropriate to change
the level or measure of the inflation target.
REPRESENTATION AND INFORMATION
Representation on the MPC
33. Throughout the existence of the MPC there have
been suggestions in the media, and elsewhere, that monetary policy
is being set to offset inflationary pressures in the South East
at the expense of the real economy in the rest of the country.
This has led to calls by commentators, including the TUC in their
written submission to our previous inquiry, that "there should
be a stronger voice for industry to influence the setting of interest
rate policy."[67]
However the Governor has refuted this suggestion on a number of
occasions stating, in 1999, for example, that "the point
... about the membership of the MPC is that they have to be experts
in monetary policy ... I would be very happy if we could find
experts of the same calibre and I do not mind where they come
from, but my concern simply is that they should be experts in
this very technical subject."[68]
We agree that MPC members should be chosen as experts in monetary
policy. However, we believe that there is an advantage in these
experts coming from different backgrounds; and we note that one
member of the MPC has a business background and another is a well
known labour market economist.
Provision of Regional Information
34. The Non-executive Directors of the Court of the
Bank of England are mandated by the Bank of England Act to determine
"whether the Committee has collected the regional, sectoral
and other information necessary for the purpose of formulating
monetary policy."[69]
Baroness Noakes, Chairman of NEDCo, explained that NEDCo looked
"at the work of the regional agents ... what kinds of ...
regional and sectoral information flows, are going to the MPC
... [and] make sure ... that they [the MPC] themselves keep under
review how they do things."[70]
In addition NEDCo occasionally hold their meeting in different
regions of the country. Sir Alan Budd confirmed that the MPC "listen
with great attention to what the [regional] agents say, because
it is very up to date information ... [we] find them extremely
valuable, because here these people are talking to the businesses
and to the firms and to the unions in the regions."[71]
We welcome the consideration the MPC give to reports from the
regional agents and emphasise their importance.
35. We note that the Bank has had difficulty getting
across the message that "the influences which determine where
interest rates go are the overall outlook for inflation ... it
is a national outlook ... not a regional one ... and not a sectoral
one."[72]
We believe that this must in part be due to the perception
that the MPC does not completely incorporate developments in the
different regions of the country into its deliberations. Hence,
in our previous report, we "encourage[d] the MPC to hold
meetings and hearings outside London."[73]
The Governor told us that there were two reasons why the Bank
had not held MPC meetings outside London: "One is that the
preparatory phase, the pre-MPC process, actually involves huge
numbers of Bank staff and it would not be realistic to take them
around the country. The other is that we are actually in purdah
during this period ... [so] none of us could speak to the public
and get our message across."[74]
However, we also note that the European Central Bank hold policy
meetings away from Frankfurt twice a year.[75]
We think that the MPC should take further steps to eradicate the
perception that it is not taking account of regional economic
factors when setting policy. We therefore recommend that the
MPC should reconsider its decision not to hold meetings outside
London, as we think the symbolic benefits would more than compensate
the logistical inconveniences involved.
APPOINTMENTS TO THE MPC
36. The membership of the MPC consists of the Governor
and Deputy Governors of the Bank, two members appointed by the
Governor of the Bank after consultation with the Chancellor (the
executives responsible for monetary policy analysis and monetary
policy operations) and four "external" members appointed
by the Chancellor of the Exchequer. All the members of the committee,
except the Governor and two deputy governors, are appointed on
three year renewable contracts.
37. Our expert witnesses raised concerns about the
length of contract. Sir Alan Budd pointed out that "three
years is a rather short time in which to judge"[76]
the performance of an individual member when their contract is
up for renewal. Mr Flemming advocated removing "the option
[of reappointment] in order to enhance the perception of independence
on the part of the members [and] at the same time possibly lengthening
their term ... with a term of about six years as a maximum."[77]
In addition, Professor Buiter, in his resignation letter to the
Chancellor, concluded that "... both the appearance and the
substance of independence of the external members of the MPC are
best served by restricting their membership to a single term."[78]
Short tenure renewable appointments run the risk that the members'
votes are influenced, towards the end of their tenure, by a desire
to gain re-selection to the Committee. We therefore repeat
the recommendation made in our report on the Accountability of
the Bank of England that the duration of the terms be increased.
38. It is also very unclear how the Chancellor chooses
the external members of the MPC. The criteria set out in the Act
are that "the person has knowledge or experience which is
likely to be relevant to the Committee's functions."[79]
This is a broad definition and currently the recruitment procedure
and specific criteria the Treasury use are extremely opaque. This
is in stark contrast to the "openness, transparency and accountability"[80]
the Treasury claims for the framework as a whole. As a counter
balance to this opacity, and a necessary part of the accountability
of the MPC, we have held public meetings to confirm the suitability
of appointments to the MPC. We discuss the confirmation hearings
in paragraphs 49 to 55 below.
SUPPORT FOR THE EXTERNALLY APPOINTED MPC MEMBERS
39. The external members of the MPC may work full
or part time at the Bank. At present two of the external members,
DeAnne Julius and Sushil Wadhwani, who came from commercial organisations,
work full-time at the Bank and two, Stephen Nickell and Christopher
Allsopp, who have academic backgrounds, work part-time at the
Bank and part-time at the London School of Economics and New College,
Oxford, respectively. As the "externals" are not bank
officials they do not have the same access to the full range of
Bank staff as the "internal" members. This led to newspaper
reports of a disagreement, in October 1999, between the external
members (particularly those without access to outside academic
researchers), and the senior management of the Bank, as to the
level of support which should be provided. The Governor explained
to us at our next hearing that this had been resolved by allocating
to each externally appointed MPC member, when required, "a
dedicated resource in the form of one post-graduate economist
and one graduate economist." He also explained that the Bank
had formalised its procedures for setting research objectives
"we ... now have six regular meetings each year to determine
the priorities ... four of them in the context of the quarterly
forecasting round ... two meetings ... to discuss longer term
research projects."[81]
40. NEDCo are mandated to ensure that MPC procedures
operate satisfactorily during the year. However on this occasion
their procedures clearly failed to work. We therefore asked Baroness
Noakes, Chairman of NEDCo, to justify their assessment in the
annual report that the Monetary Policy Committee "procedures
... operated satisfactorily."[82]
Baroness Noakes explained that NEDCo "looked at [the issue]
... and encouraged the Bank to be quite explicit about how that
process had gone on in its review of monetary policy procedures
... in the light of that full explanation and bearing in mind
that we found no harm done to the process of monetary policy,
we found it relatively straight forward to reach the conclusion
that we did."[83]
Nevertheless, despite Baroness Noakes' explanation, we note that
the issue was only fully resolved after it had been made public
and became a focus of one of our public hearings. We believe
that the Non-Executive Directors need to be much more pro-active
in ensuring that the procedures of the MPC operate fairly with
respect to both internal and external members.
29 Eighth
Report, Session 1998-99, The Monetary Policy Committee-Two
Years On, HC 505, Q 68 (and para 29 of the Report). Back
30 Ibid,
Q 2. Back
31 Q 122. Back
32 Eighth
Report, Session 1998-99, The Monetary Policy Committee-Two
Years On, HC 505, para 31. Back
33 Q 122. Back
34 Q 400,
401. Back
35 Bank
Quarterly Bulletin Volume 39 No 2 p 161-176. Back
36 February
1993 Inflation Report, p 3. Back
37 Bank
of England Act 1998, section 18(2). Back
38 Ibid,
section 18(5). Back
39 August
2000 Inflation Report, p 63. Back
40 Ibid,
p 49. Back
41 Q 122. Back
42 Q 243. Back
43 Donald
L Kohn, Report to the Non-Executive Directors of the Court of
the Bank of England on Monetary Policy Processes and the Work
of Monetary Analysis, p 14. Back
44 Q 243. Back
45 Q 212. Back
46 Q 212. Back
47 "The
Inflation Forecast", National Institute of Economic and
Social Research Review, January 2001. Back
48 Ibid,
p 65. Back
49 Q 415. Back
50 Donald
L Kohn, Report to the Non-Executive Directors of the Court of
the Bank of England on Monetary Policy Processes and the Work
of Monetary Analysis, p 13. Back
51 Q 305. Back
52 Central
Bank Independence and the Conduct of Monetary Policy in the United
Kingdom, IMF Working paper
WP/99/170, December 1999, p 15. Back
53 Q 129. Back
54 Q 129. Back
55 Q 131. Back
56 Q 131. Back
57 Q 305. Back
58 Q 306. Back
59 Bank
of England Act 1998, section 12(1)(a). Back
60 Q 132. Back
61 Q 133. Back
62 Ibid. Back
63 Ibid. Back
64 Q 341. Back
65 Q 346. Back
66 Q 347. Back
67 Eighth
Report, Session 1998-99, The Monetary Policy Committee-Two
Years On, HC 505, Appendix 9. Back
68 February
1999 Inflation Report hearing, HC (1998-99) 268-i & ii, Q
193. Back
69 Bank
of England Act 1998, section 16(2). Back
70 Q 5. Back
71 Q 170. Back
72 February
2000 Inflation Report hearing, HC (1999-2000) 286-i & ii,
Q 93. Back
73 Eighth
Report, Session 1998-99, The Monetary Policy Committee-Two
Years On, HC 505, Conclusion (g). Back
74 First
Report, Session 1999-2000, Research Assistance for Monetary
Policy Committee Members, HC 43, Q 206. Back
75 European
Central Bank Annual Report 1999, Chapter XI, p 135. Back
76 Q 90. Back
77 Q90,
91. Back
78 Letter
from Willem Buiter to the Chancellor, 18 January 2000 (reproduced
with Treasury News Release 16/00, 11 February 2000). Back
79 Bank
of England Act 1998, section 13(4). Back
80 Budget
2001, HC (2000-01) 279, p 18 para 2.4. Back
81 First
Report, Session 1999-2000, Research Assistance for Monetary
Policy Committee Members, HC 43, Q 74. Back
82 Report
by the Non-Executive Directors of the Bank of England, Bank of
England Annual Report 2000. Back
83 Q 6. Back
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